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MarketScreener Homepage  >  Equities  >  Nasdaq  >  Microsoft Corporation    MSFT

MICROSOFT CORPORATION

(MSFT)
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MICROSOFT : form 10-K)

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07/31/2020 | 07:34am EDT

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS

                                 OF OPERATIONS

The following Management's Discussion and Analysis of Financial Condition and
Results of Operations ("MD&A") is intended to help the reader understand the
results of operations and financial condition of Microsoft Corporation. MD&A is
provided as a supplement to, and should be read in conjunction with, our
consolidated financial statements and the accompanying Notes to Financial
Statements (Part II, Item 8 of this Form 10-K).

                                    OVERVIEW

Microsoft is a technology company whose mission is to empower every person and
every organization on the planet to achieve more. We strive to create local
opportunity, growth, and impact in every country around the world. Our platforms
and tools help drive small business productivity, large business
competitiveness, and public-sector efficiency. They also support new startups,
improve educational and health outcomes, and empower human ingenuity.

We generate revenue by offering a wide range of cloud-based and other services
to people and businesses; licensing and supporting an array of software
products; designing, manufacturing, and selling devices; and delivering relevant
online advertising to a global audience. Our most significant expenses are
related to compensating employees; designing, manufacturing, marketing, and
selling our products and services; datacenter costs in support of our
cloud-based services; and income taxes.

As the world responds to the outbreak of a novel strain of the coronavirus
("COVID-19"), we are working to do our part by ensuring the safety of our
employees, striving to protect the health and well-being of the communities in
which we operate, and providing technology and resources to our customers to
help them do their best work while remote.

Highlights from fiscal year 2020 compared with fiscal year 2019 included:

• Commercial cloud revenue increased 36% to $51.7 billion.

• Office Commercial products and cloud services revenue increased 12%,

driven by Office 365 Commercial growth of 24%.

• Office Consumer products and cloud services revenue increased 11%, with

continued growth in Office 365 Consumer subscribers to 42.7 million.


  • LinkedIn revenue increased 20%.

• Dynamics products and cloud services revenue increased 14%, driven by

Dynamics 365 growth of 42%.

• Server products and cloud services revenue increased 27%, driven by Azure

        growth of 56%.


  • Enterprise Services revenue increased 5%.


  • Windows Commercial products and cloud services revenue increased 18%.

• Windows original equipment manufacturer licensing ("Windows OEM") revenue

        increased 9%.


  • Surface revenue increased 8%.


  • Xbox content and services revenue increased 11%.

     •  Search advertising revenue, excluding traffic acquisition costs,
was
        relatively unchanged.


Industry Trends

Our industry is dynamic and highly competitive, with frequent changes in both
technologies and business models. Each industry shift is an opportunity to
conceive new products, new technologies, or new ideas that can further transform
the industry and our business. At Microsoft, we push the boundaries of what is
possible through a broad range of research and development activities that seek
to identify and address the changing demands of customers and users, industry
trends, and competitive forces.

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                                     Item 7


Economic Conditions, Challenges, and Risks


The markets for software, devices, and cloud-based services are dynamic and
highly competitive. Our competitors are developing new software and devices,
while also deploying competing cloud-based services for consumers and
businesses. The devices and form factors customers prefer evolve rapidly, and
influence how users access services in the cloud, and in some cases, the user's
choice of which suite of cloud-based services to use. We must continue to evolve
and adapt over an extended time in pace with this changing environment. The
investments we are making in infrastructure and devices will continue to
increase our operating costs and may decrease our operating margins.

Our success is highly dependent on our ability to attract and retain qualified
employees. We hire a mix of university and industry talent worldwide. We compete
for talented individuals globally by offering an exceptional working
environment, broad customer reach, scale in resources, the ability to grow one's
career across many different products and businesses, and competitive
compensation and benefits. Aggregate demand for our software, services, and
devices is correlated to global macroeconomic and geopolitical factors, which
remain dynamic.

Our international operations provide a significant portion of our total revenue
and expenses. Many of these revenue and expenses are denominated in currencies
other than the U.S. dollar. As a result, changes in foreign exchange rates may
significantly affect revenue and expenses. Strengthening of the U.S. dollar
relative to certain foreign currencies did not significantly impact reported
revenue or expenses from our international operations in the first and second
quarters of fiscal year 2019, and reduced reported revenue and expenses from our
international operations in the third and fourth quarters of fiscal year 2019.
Strengthening of the U.S. dollar relative to certain foreign currencies reduced
reported revenue and expenses from our international operations in fiscal year
2020.

Refer to Risk Factors (Part I, Item 1A of this Form 10-K) for a discussion of these factors and other risks.

COVID-19


In fiscal year 2020, the COVID-19 pandemic impacted our business operations,
including our employees, customers, partners, and communities, and we saw the
following trends in our financial operating results. In the Productivity and
Business Processes and Intelligent Cloud segments, cloud usage and demand
increased as customers shifted to work and learn from home. We also experienced
a slowdown in transactional licensing, particularly in small and medium
businesses, and LinkedIn was negatively impacted by the weak job market and
reductions in advertising spend. In the More Personal Computing segment, Windows
OEM, Surface, and Gaming benefited from increased demand to support remote
work-, play-, and learn-from-home scenarios, while Search was negatively
impacted by reductions in advertising spend. The COVID-19 pandemic may continue
to impact our business operations and financial operating results, and there is
substantial uncertainty in the nature and degree of its continued effects over
time.

The extent to which the COVID-19 pandemic impacts our business going forward
will depend on numerous evolving factors we cannot reliably predict, including
the duration and scope of the pandemic; governmental, business, and individuals'
actions in response to the pandemic; and the impact on economic activity
including the possibility of recession or financial market instability. These
factors may adversely impact consumer, business, and government spending on
technology as well as customers' ability to pay for our products and services on
an ongoing basis. This uncertainty also affects management's accounting
estimates and assumptions, which could result in greater variability in a
variety of areas that depend on these estimates and assumptions, including
investments, receivables, and forward-looking guidance. Refer to Risk Factors
(Part I, Item 1A of this Form 10-K) for a discussion of these factors and other
risks.

Seasonality

Our revenue fluctuates quarterly and is generally higher in the second and fourth quarters of our fiscal year. Second quarter revenue is driven by corporate year-end spending trends in our major markets and holiday season spending by consumers, and fourth quarter revenue is driven by the volume of multi-year on-premises contracts executed during the period.

                                       36

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                                     Item 7



Reportable Segments

We report our financial performance based on the following segments:
Productivity and Business Processes, Intelligent Cloud, and More Personal
Computing. The segment amounts included in MD&A are presented on a basis
consistent with our internal management reporting. All differences between our
internal management reporting basis and accounting principles generally accepted
in the United States of America ("GAAP"), along with certain corporate-level and
other activity, are included in Corporate and Other.

Additional information on our reportable segments is contained in Note 19 - Segment Information and Geographic Data of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K).

Metrics


We use metrics in assessing the performance of our business and to make informed
decisions regarding the allocation of resources. We disclose metrics to enable
investors to evaluate progress against our ambitions, provide transparency into
performance trends, and reflect the continued evolution of our products and
services. Our commercial and other business metrics are fundamentally connected
based on how customers use our products and services. The metrics are disclosed
in the MD&A or the Notes to Financial Statements (Part II, Item 8 of this Form
10-K). Financial metrics are calculated based on GAAP results and growth
comparisons relate to the corresponding period of last fiscal year.

Commercial

Our commercial business primarily consists of Server products and cloud services, Office Commercial, Windows Commercial, the commercial portion of LinkedIn, Enterprise Services, and Dynamics. Our commercial metrics allow management and investors to assess the overall health of our commercial business and include leading indicators of future performance.




Commercial remaining performance obligation   Commercial portion of revenue allocated to
                                              remaining performance obligations, which
                                              includes unearned revenue and amounts that will
                                              be invoiced and recognized as revenue in future
                                              periods

Commercial cloud revenue                      Revenue from our commercial cloud business,
                                              which includes Office 365 Commercial, Azure, the
                                              commercial portion of LinkedIn, Dynamics 365,
                                              and other commercial cloud properties

Commercial cloud gross margin percentage      Gross margin percentage for our commercial cloud
                                              business




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                                     Item 7


Productivity and Business Processes and Intelligent Cloud


Metrics related to our Productivity and Business Processes and Intelligent Cloud
segments assess the health of our core businesses within these segments. The
metrics reflect our cloud and on-premises product strategies and trends.



Office Commercial products and cloud services revenue growth Revenue from Office Commercial products and

                                                               cloud 

services, including Office 365

subscriptions, the Office 365 portion of

                                                               Microsoft

365 Commercial subscriptions, and

                                                               Office 

licensed on-premises, comprising Office,

                                                               Exchange, 

SharePoint, Microsoft Teams, Office

                                                               365 Security 

and Compliance, and Skype for

                                                               Business, 

and related Client Access Licenses

                                                               ("CALs")

Office Consumer products and cloud services revenue growth Revenue from Office Consumer products and cloud

                                                               services, 

including Microsoft 365 Consumer

                                                               (formerly 

Office 365 Consumer) subscriptions and

                                                               Office 

licensed on-premises


Office 365 Commercial seat growth                              The number 

of Office 365 Commercial seats at end

                                                               of period 

where seats are paid users covered by

                                                               an Office 

365 Commercial subscription


Office 365 Consumer subscribers                                The number 

of Office 365 Consumer subscribers at

                                                               end of 

period


Dynamics products and cloud services revenue growth            Revenue from 

Dynamics products and cloud

                                                               services, 

including Dynamics 365, a set of

                                                               cloud-based 

applications across ERP and CRM,

                                                               Dynamics ERP on-premises, and Dynamics CRM
                                                               on-premises

LinkedIn revenue growth                                        Revenue from LinkedIn, including Talent
                                                               Solutions, Learning Solutions, Marketing
                                                               Solutions, Sales Solutions, and Premium
                                                               Subscriptions

Server products and cloud services revenue growth              Revenue from 

Server products and cloud services,

                                                               including 

Azure; SQL Server, Windows Server,

                                                               Visual 

Studio, System Center, and related CALs;

                                                               and GitHub

Enterprise Services revenue growth                             Revenue from 

Enterprise Services, including

                                                               Premier 

Support Services and Microsoft

                                                               Consulting Services


More Personal Computing

Metrics related to our More Personal Computing segment assess the performance of
key lines of business within this segment. These metrics provide strategic
product insights which allow us to assess the performance across our commercial
and consumer businesses. As we have diversity of target audiences and sales
motions within the Windows business, we monitor metrics that are reflective of
those varying motions.



Windows OEM Pro revenue growth                                  Revenue 

from sales of Windows Pro licenses sold

                                                                through the 

OEM channel, which primarily

                                                                addresses 

demand in the commercial market


Windows OEM non-Pro revenue growth                              Revenue 

from sales of Windows non-Pro licenses

                                                                sold 

through the OEM channel, which primarily

                                                                addresses 

demand in the consumer market

Windows Commercial products and cloud services revenue growth Revenue from Windows Commercial products and

                                                                cloud 

services, comprising volume licensing of

                                                                the Windows 

operating system, Windows cloud

                                                                services, 

and other Windows commercial offerings


Surface revenue                                                 Revenue 

from Surface devices and accessories


Xbox content and services revenue growth                        Revenue 

from Xbox content and services,

                                                                comprising 

Xbox Live (transactions,

subscriptions, cloud services, and advertising),

                                                                video 

games, and third-party video game

                                                                royalties

Search advertising revenue, excluding TAC, growth               Revenue 

from search advertising excluding

                                                                traffic 

acquisition costs ("TAC") paid to Bing

                                                                Ads network publishers




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                         SUMMARY RESULTS OF OPERATIONS



                                                                                                       Percentage        Percentage
                                                                                                      Change 2020       Change 2019

(In millions, except percentages and per share amounts) 2020

  2019          2018       Versus 2019       Versus 2018


Revenue                                                   $ 143,015$ 125,843$ 110,360               14%               14%
Gross margin                                                 96,937        82,933        72,007               17%               15%
Operating income                                             52,959        42,959        35,058               23%               23%
Net income                                                   44,281        39,240        16,571               13%              137%
Diluted earnings per share                                     5.76          5.06          2.13               14%              138%

Non-GAAP net income                                          44,281        36,830        30,267               20%               22%
Non-GAAP diluted earnings per share                            5.76          4.75          3.88               21%               22%





Non-GAAP net income and diluted earnings per share ("EPS") exclude the net tax
impact of transfer of intangible properties in fiscal year 2019 and the net tax
impact of the Tax Cuts and Jobs Act ("TCJA") in fiscal years 2019 and 2018.
Refer to the Non-GAAP Financial Measures section below for a reconciliation of
our financial results reported in accordance with GAAP to non-GAAP financial
results.

Fiscal Year 2020 Compared with Fiscal Year 2019


Revenue increased $17.2 billion or 14%, driven by growth across each of our
segments. Intelligent Cloud revenue increased, driven by server products and
cloud services. Productivity and Business Processes revenue increased, driven by
Office Commercial and LinkedIn. More Personal Computing revenue increased,
driven by Windows and Surface.

Gross margin increased $14.0 billion or 17%, driven by growth across each of our
segments. Gross margin percentage increased, driven by sales mix shift to higher
margin businesses. Commercial cloud gross margin percentage increased 4 points
to 67%, primarily driven by improvement in Azure.

Operating income increased $10.0 billion or 23%, driven by growth across each of our segments.


Key changes in expenses were:

     •  Cost of revenue increased $3.2 billion or 7%, driven by growth in
        commercial cloud.

• Research and development expenses increased $2.4 billion or 14%, driven by

        investments in cloud engineering, LinkedIn, Devices, and Gaming.

• Sales and marketing expenses increased $1.4 billion or 8%, driven by

investments in LinkedIn and commercial sales, and an increase in bad debt

expense.

• General and administrative expenses increased $226 million or 5%, driven

by charges associated with the closing of our Microsoft Store physical

        locations, offset in part by a reduction in business taxes and legal
        expenses.

Gross margin and operating income included an unfavorable foreign currency impact of 2% and 4%, respectively.


Prior year net income included a $2.6 billion net income tax benefit related to
intangible property transfers and a $157 million net charge related to the
enactment of the TCJA, which together resulted in an increase to net income and
diluted EPS of $2.4 billion and $0.31, respectively.

Fiscal Year 2019 Compared with Fiscal Year 2018


Revenue increased $15.5 billion or 14%, driven by growth across each of our
segments. Intelligent Cloud revenue increased, driven by server products and
cloud services. Productivity and Business Processes revenue increased, driven by
Office and LinkedIn. More Personal Computing revenue increased, driven by
Surface, Gaming, and Windows.

Gross margin increased $10.9 billion or 15%, driven by growth across each of our
segments. Gross margin percentage increased slightly, due to gross margin
percentage improvement across each of our segments and favorable segment sales
mix. Gross margin included a 5 percentage point improvement in commercial cloud,
primarily from Azure.

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                                     Item 7


Operating income increased $7.9 billion or 23%, driven by growth across each of our segments.


Key changes in expenses were:

• Cost of revenue increased $4.6 billion or 12%, driven by growth in

commercial cloud, Surface, and Gaming.

• Research and development expenses increased $2.2 billion or 15%, driven by

investments in cloud and artificial intelligence ("AI") engineering,

        Gaming, LinkedIn, and GitHub.


     •  Sales and marketing expenses increased $744 million or 4%, driven by

investments in commercial sales capacity, LinkedIn, and GitHub, offset in

part by a decrease in marketing. Sales and marketing expenses included a

favorable foreign currency impact of 2%.



Fiscal year 2019 net income included a $2.6 billion net income tax benefit
related to intangible property transfers and a $157 million net charge related
to the enactment of the TCJA, which together resulted in an increase to net
income and diluted EPS of $2.4 billion and $0.31, respectively. Fiscal year 2018
net income and diluted EPS were negatively impacted by the net charge related to
the enactment of the TCJA, which resulted in a decrease to net income and
diluted EPS of $13.7 billion and $1.75, respectively.

                         SEGMENT RESULTS OF OPERATIONS



                                                                                   Percentage        Percentage
                                                                                  Change 2020       Change 2019
(In millions, except percentages)          2020          2019          2018       Versus 2019       Versus 2018


Revenue

Productivity and Business Processes $ 46,398$ 41,160$ 35,865

              13%               15%
Intelligent Cloud                        48,366        38,985        32,219               24%               21%
More Personal Computing                  48,251        45,698        42,276                6%                8%


Total                                 $ 143,015$ 125,843$ 110,360               14%               14%


Operating Income

Productivity and Business Processes $ 18,724$ 16,219$ 12,924

              15%               25%
Intelligent Cloud                        18,324        13,920        11,524               32%               21%
More Personal Computing                  15,911        12,820        10,610               24%               21%


Total                                 $  52,959$  42,959$  35,058               23%               23%



Reportable Segments

Fiscal Year 2020 Compared with Fiscal Year 2019

Productivity and Business Processes

Revenue increased $5.2 billion or 13%.


     •  Office Commercial products and cloud services revenue increased $3.1
        billion or 12%, driven by Office 365 Commercial, offset in part by lower
        revenue from products licensed on-premises, reflecting a continued shift
        to cloud offerings. Office 365 Commercial revenue grew 24%, due to seat
        growth and higher revenue per user.

• Office Consumer products and cloud services revenue increased $458 million

or 11%, driven by Microsoft 365 Consumer subscription revenue and

transactional strength in Japan. Office 365 Consumer subscribers increased

        23% to 42.7 million with increased demand from remote work and learn
        scenarios.

• LinkedIn revenue increased $1.3 billion or 20%, driven by growth across

all businesses.

• Dynamics products and cloud services revenue increased 14%, driven by

        Dynamics 365 growth of 42%.


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                                     Item 7


Operating income increased $2.5 billion or 15%.

• Gross margin increased $4.1 billion or 13%, driven by growth in Office

Commercial and LinkedIn. Gross margin percentage was relatively unchanged,

due to gross margin percentage improvement in LinkedIn, offset in part by

an increased mix of cloud offerings.

• Operating expenses increased $1.6 billion or 11%, driven by investments in

LinkedIn and cloud engineering.

Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 2%, 2%, and 4%, respectively.

Intelligent Cloud

Revenue increased $9.4 billion or 24%.

• Server products and cloud services revenue increased $8.8 billion or 27%,

driven by Azure. Azure revenue grew 56%, due to growth in our

consumption-based services. Server products revenue increased 8%, due to

hybrid and premium solutions, as well as demand related to SQL Server 2008

and Windows Server 2008 end of support.

• Enterprise Services revenue increased $285 million or 5%, driven by growth

in Premier Support Services.

Operating income increased $4.4 billion or 32%.


     •  Gross margin increased $6.9 billion or 26%, driven by growth in server
        products and cloud services revenue and cloud services scale and
        efficiencies. Gross margin percentage increased slightly, due to gross

margin percentage improvement in Azure, offset in part by an increased mix

of cloud offerings.

• Operating expenses increased $2.5 billion or 19%, driven by investments in

Azure.

Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 2%, 2%, and 4%, respectively.

More Personal Computing

Revenue increased $2.6 billion or 6%.

• Windows revenue increased $1.9 billion or 9%, driven by growth in Windows

Commercial and Windows OEM. Windows Commercial products and cloud services

revenue increased 18%, driven by increased demand for Microsoft 365.

Windows OEM revenue increased 9%, ahead of PC market growth. Windows OEM

Pro revenue grew 11%, driven by Windows 7 end of support and healthy

Windows 10 demand, offset in part by weakness in small and medium

businesses. Windows OEM non-Pro revenue grew 5%, driven by consumer demand

from remote work and learn scenarios.

• Surface revenue increased $457 million or 8%, driven by increased demand

from remote work and learn scenarios.

• Gaming revenue increased $189 million or 2%, driven by an increase in Xbox

content and services, offset in part by a decrease in Xbox hardware. Xbox

content and services revenue increased $943 million or 11% on a strong

prior year comparable, driven by growth in Minecraft, third-party titles,

and subscriptions, accelerated by higher engagement during stay-at-home

        guidelines. Xbox hardware revenue declined 31%, primarily due to a
        decrease in volume and price of consoles sold.


     •  Search advertising revenue increased $112 million or 1%. Search

advertising revenue, excluding traffic acquisition costs, was relatively

unchanged.

Operating income increased $3.1 billion or 24%.

• Gross margin increased $3.0 billion or 12%, driven by growth in Windows,

Gaming, and Surface. Gross margin percentage increased, due to sales mix

shift to higher margin businesses and gross margin percentage improvement

        in Gaming.


     •  Operating expenses decreased $119 million or 1%, driven by the
        redeployment of engineering resources, offset in part by charges

associated with the closing of our Microsoft Store physical locations and

        investments in Gaming.


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                                     Item 7


Gross margin and operating income included an unfavorable foreign currency impact of 2% and 3%, respectively.

Fiscal Year 2019 Compared with Fiscal Year 2018

Productivity and Business Processes

Revenue increased $5.3 billion or 15%.


     •  Office Commercial products and cloud services revenue increased $3.2
        billion or 13%, driven by Office 365 Commercial, offset in part by lower
        revenue from products licensed on-premises, reflecting a continued shift

to cloud offerings. Office 365 Commercial grew 33%, due to growth in seats

and higher average revenue per user.

• Office Consumer products and cloud services revenue increased $286 million

or 7%, driven by Microsoft 365 Consumer, due to recurring subscription

revenue and transactional strength in Japan.

• LinkedIn revenue increased $1.5 billion or 28%, driven by growth across

each line of business.

• Dynamics products and cloud services revenue increased 15%, driven by

Dynamics 365 growth.

Operating income increased $3.3 billion or 25%, including an unfavorable foreign currency impact of 2%.

• Gross margin increased $4.1 billion or 15%, driven by growth in Office

Commercial and LinkedIn. Gross margin percentage increased slightly, due

        to gross margin percentage improvement in LinkedIn and Office 365
        Commercial, offset in part by an increased mix of cloud offerings.

• Operating expenses increased $806 million or 6%, driven by investments in

LinkedIn and cloud engineering, offset in part by a decrease in marketing.



Intelligent Cloud

Revenue increased $6.8 billion or 21%.

• Server products and cloud services revenue, including GitHub, increased

$6.5 billion or 25%, driven by Azure. Azure revenue growth was 72%, due to

higher infrastructure-as-a-service and platform-as-a-service

consumption-based and per user-based services. Server products revenue

increased 6%, due to continued demand for premium versions and hybrid

solutions, GitHub, and demand ahead of end-of-support for SQL Server 2008

and Windows Server 2008.

• Enterprise Services revenue increased $278 million or 5%, driven by growth

in Premier Support Services and Microsoft Consulting Services.

Operating income increased $2.4 billion or 21%.


     •  Gross margin increased $4.8 billion or 22%, driven by growth in server
        products and cloud services revenue and cloud services scale and
        efficiencies. Gross margin percentage increased slightly, due to gross

margin percentage improvement in Azure, offset in part by an increased mix

of cloud offerings.

• Operating expenses increased $2.4 billion or 22%, driven by investments in

cloud and AI engineering, GitHub, and commercial sales capacity.

More Personal Computing

Revenue increased $3.4 billion or 8%.

• Windows revenue increased $877 million or 4%, driven by growth in Windows

        Commercial and Windows OEM, offset in part by a decline in patent
        licensing. Windows Commercial products and cloud services revenue
        increased 14%, driven by an increased mix of multi-year agreements that

carry higher in-quarter revenue recognition. Windows OEM revenue increased

4%. Windows OEM Pro revenue grew 10%, ahead of the commercial PC market,

driven by healthy Windows 10 demand. Windows OEM non-Pro revenue declined

        7%, below the consumer PC market, driven by continued pressure in the
        entry level category.


     •  Surface revenue increased $1.1 billion or 23%, with strong growth across
        commercial and consumer.


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                                     Item 7


• Gaming revenue increased $1.0 billion or 10%, driven by Xbox software and

        services growth of 19%, primarily due to third-party title strength and
        subscriptions growth, offset in part by a decline in Xbox hardware of 13%
        primarily due to a decrease in volume of consoles sold.


     •  Search advertising revenue increased $616 million or 9%. Search
        advertising revenue, excluding traffic acquisition costs, increased 13%,
        driven by higher revenue per search.

Operating income increased $2.2 billion or 21%, including an unfavorable foreign currency impact of 2%.

• Gross margin increased $2.0 billion or 9%, driven by growth in Windows,

Gaming, and Search. Gross margin percentage increased slightly, due to

sales mix shift to higher gross margin businesses in Windows and Gaming.



  • Operating expenses decreased $172 million or 1%.


                               OPERATING EXPENSES

Research and Development



                                                                                 Percentage        Percentage
                                                                                Change 2020       Change 2019
(In millions, except percentages)        2020          2019          2018   

Versus 2019 Versus 2018


Research and development            $  19,269$  16,876$  14,726               14%               15%
As a percent of revenue                   13%           13%           13%              0ppt              0ppt




Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code and services content.

Fiscal Year 2020 Compared with Fiscal Year 2019

Research and development expenses increased $2.4 billion or 14%, driven by investments in cloud engineering, LinkedIn, Devices, and Gaming.

Fiscal Year 2019 Compared with Fiscal Year 2018

Research and development expenses increased $2.2 billion or 15%, driven by investments in cloud and AI engineering, Gaming, LinkedIn, and GitHub.


Sales and Marketing



                                                                                 Percentage        Percentage
                                                                                Change 2020       Change 2019
(In millions, except percentages)        2020          2019          2018   

Versus 2019 Versus 2018


Sales and marketing                 $  19,598$  18,213$  17,469                8%                4%
As a percent of revenue                   14%           14%           16%              0ppt            (2)ppt





Sales and marketing expenses include payroll, employee benefits, stock-based
compensation expense, and other headcount-related expenses associated with sales
and marketing personnel, and the costs of advertising, promotions, trade shows,
seminars, and other programs.

Fiscal Year 2020 Compared with Fiscal Year 2019

Sales and marketing expenses increased $1.4 billion or 8%, driven by investments in LinkedIn and commercial sales, and an increase in bad debt expense.

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                                     Item 7


Fiscal Year 2019 Compared with Fiscal Year 2018


Sales and marketing expenses increased $744 million or 4%, driven by investments
in commercial sales capacity, LinkedIn, and GitHub, offset in part by a decrease
in marketing. Expenses included a favorable foreign currency impact of 2%.

General and Administrative



                                                                                 Percentage        Percentage
                                                                                Change 2020       Change 2019
(In millions, except percentages)        2020          2019          2018   

Versus 2019 Versus 2018

General and administrative $ 5,111$ 4,885$ 4,754

             5%                3%
As a percent of revenue                    4%            4%            4%              0ppt              0ppt





General and administrative expenses include payroll, employee benefits,
stock-based compensation expense, severance expense, and other headcount-related
expenses associated with finance, legal, facilities, certain human resources and
other administrative personnel, certain taxes, and legal and other
administrative fees.

Fiscal Year 2020 Compared with Fiscal Year 2019

General and administrative expenses increased $226 million or 5%, driven by charges associated with the closing of our Microsoft Store physical locations, offset in part by a reduction in business taxes and legal expenses.

Fiscal Year 2019 Compared with Fiscal Year 2018

General and administrative expenses increased $131 million or 3%.

                          OTHER INCOME (EXPENSE), NET

The components of other income (expense), net were as follows:



(In millions)


Year Ended June 30,                                 2020         2019          2018

Interest and dividends income                   $  2,680$  2,762     $ 

2,214

Interest expense                                  (2,591 )     (2,686 )      (2,733 )
Net recognized gains on investments                   32          648       

2,399

Net gains (losses) on derivatives                    187          144          (187 )
Net losses on foreign currency remeasurements       (191 )        (82 )        (218 )
Other, net                                           (40 )        (57 )         (59 )


Total                                           $     77$    729$   1,416

We use derivative instruments to: manage risks related to foreign currencies, equity prices, interest rates, and credit; enhance investment returns; and facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are not designated as hedging instruments are primarily recognized in other income (expense), net.

Fiscal Year 2020 Compared with Fiscal Year 2019


Interest and dividends income decreased due to lower yields, offset in part by
higher average portfolio balances on fixed-income securities. Interest expense
decreased due to capitalization of interest expense and a decrease in
outstanding long-term debt due to debt maturities, offset in part by debt
exchange transaction fees and higher finance lease expense. Net recognized gains
on investments decreased due to lower gains and higher other-than-temporary
impairments on equity investments, offset in part by gains on fixed income
securities in the current period compared to losses in the prior period. Net
gains on derivatives increased due to higher gains on foreign exchange and
equity derivatives.

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                                     Item 7


Fiscal Year 2019 Compared with Fiscal Year 2018


Interest and dividends income increased primarily due to higher yields on
fixed-income securities. Interest expense decreased primarily driven by a
decrease in outstanding long-term debt due to debt maturities, offset in part by
higher finance lease expense. Net recognized gains on investments decreased
primarily due to lower gains on sales of equity investments. Net gains on
derivatives includes gains on foreign exchange and interest rate derivatives in
the current period as compared to losses in the prior period.

                                  INCOME TAXES

Effective Tax Rate

Fiscal Year 2020 Compared with Fiscal Year 2019


Our effective tax rate for fiscal years 2020 and 2019 was 17% and 10%,
respectively. The increase in our effective tax rate for fiscal year 2020
compared to fiscal year 2019 was primarily due to a $2.6 billion net income tax
benefit in the fourth quarter of fiscal year 2019 related to intangible property
transfers. Our effective tax rate was lower than the U.S. federal statutory
rate, primarily due to earnings taxed at lower rates in foreign jurisdictions
resulting from producing and distributing our products and services through our
foreign regional operations centers in Ireland and Puerto Rico, and tax benefits
relating to stock-based compensation.

The mix of income before income taxes between the U.S. and foreign countries
impacted our effective tax rate as a result of the geographic distribution of,
and customer demand for, our products and services. In fiscal year 2020, our
U.S. income before income taxes was $24.1 billion and our foreign income before
income taxes was $28.9 billion. In fiscal year 2019, our U.S. income before
income taxes was $15.8 billion and our foreign income before income taxes was
$27.9 billion.

Fiscal Year 2019 Compared with Fiscal Year 2018


Our effective tax rate for fiscal years 2019 and 2018 was 10% and 55%,
respectively. The decrease in our effective tax rate for fiscal year 2019
compared to fiscal year 2018 was primarily due to the net charge related to the
enactment of the TCJA in the second quarter of fiscal year 2018 and a $2.6
billion net income tax benefit in the fourth quarter of fiscal year 2019 related
to intangible property transfers. Our effective tax rate was lower than the U.S.
federal statutory rate, primarily due to the tax benefit related to intangible
property transfers, and earnings taxed at lower rates in foreign jurisdictions
resulting from producing and distributing our products and services through our
foreign regional operations centers in Ireland, Singapore, and Puerto Rico.

The mix of income before income taxes between the U.S. and foreign countries
impacted our effective tax rate as a result of the geographic distribution of,
and customer demand for, our products and services. In fiscal year 2019, our
U.S. income before income taxes was $15.8 billion and our foreign income before
income taxes was $27.9 billion. In fiscal year 2018, our U.S. income before
income taxes was $11.5 billion and our foreign income before income taxes was
$24.9 billion.

Tax Cuts and Jobs Act

On December 22, 2017, the TCJA was enacted into law, which significantly changed
existing U.S. tax law and included numerous provisions that affect our business.
We recorded a provisional net charge of $13.7 billion related to the enactment
of the TCJA in fiscal year 2018, and adjusted the provisional net charge by
recording additional tax expense of $157 million in fiscal year 2019 pursuant to
Securities and Exchange Commission Staff Accounting Bulletin No. 118.

In fiscal year 2019, in response to the TCJA and recently issued regulations, we
transferred certain intangible properties held by our foreign subsidiaries to
the U.S. and Ireland. The transfers of intangible properties resulted in a $2.6
billion net income tax benefit recorded in the fourth quarter of fiscal year
2019, as the value of future tax deductions exceeded the current tax liability
from foreign jurisdictions and U.S. global intangible low-taxed income tax.

Refer to Note 12 - Income Taxes of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion.

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                                     Item 7



Uncertain Tax Positions

We settled a portion of the Internal Revenue Service ("IRS") audit for tax years
2004 to 2006 in fiscal year 2011. In February 2012, the IRS withdrew its 2011
Revenue Agents Report related to unresolved issues for tax years 2004 to 2006
and reopened the audit phase of the examination. We also settled a portion of
the IRS audit for tax years 2007 to 2009 in fiscal year 2016, and a portion of
the IRS audit for tax years 2010 to 2013 in fiscal year 2018. We remain under
audit for tax years 2004 to 2013. In April 2020, the IRS commenced the audit for
tax years 2014 to 2017.

As of June 30, 2020, the primary unresolved issues for the IRS audits relate to
transfer pricing, which could have a material impact in our consolidated
financial statements when the matters are resolved. We believe our allowances
for income tax contingencies are adequate. We have not received a proposed
assessment for the unresolved issues and do not expect a final resolution of
these issues in the next 12 months. Based on the information currently
available, we do not anticipate a significant increase or decrease to our tax
contingencies for these issues within the next 12 months.

We are subject to income tax in many jurisdictions outside the U.S. Our
operations in certain jurisdictions remain subject to examination for tax years
1996 to 2019, some of which are currently under audit by local tax authorities.
The resolution of each of these audits is not expected to be material to our
consolidated financial statements.

                          NON-GAAP FINANCIAL MEASURES

Non-GAAP net income and diluted EPS are non-GAAP financial measures which
exclude the net tax impact of transfer of intangible properties in fiscal year
2019 and the net tax impact of the TCJA in fiscal years 2019 and 2018. We
believe these non-GAAP measures aid investors by providing additional insight
into our operational performance and help clarify trends affecting our business.
For comparability of reporting, management considers non-GAAP measures in
conjunction with GAAP financial results in evaluating business performance.
These non-GAAP financial measures presented should not be considered a
substitute for, or superior to, the measures of financial performance prepared
in accordance with GAAP.

The following table reconciles our financial results reported in accordance with GAAP to non-GAAP financial results:




                                                                                Percentage        Percentage
(In millions, except percentages                                               Change 2020       Change 2019
and per share amounts)                  2020          2019          2018       Versus 2019       Versus 2018


Net income                         $  44,281$  39,240$  16,571               13%              137%
Net tax impact of transfer of
intangible properties                      0        (2,567 )           0                 *                 *
Net tax impact of the TCJA                 0           157        13,696                 *                 *


Non-GAAP net income                $  44,281$  36,830$  30,267               20%               22%


Diluted earnings per share $ 5.76$ 5.06$ 2.13

            14%              138%
Net tax impact of transfer of
intangible properties                      0         (0.33 )           0                 *                 *
Net tax impact of the TCJA                 0          0.02          1.75                 *                 *


Non-GAAP diluted earnings per
share                              $    5.76$    4.75$    3.88               21%               22%





* Not meaningful.


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                                     Item 7



                              FINANCIAL CONDITION

Cash, Cash Equivalents, and Investments


Cash, cash equivalents, and short-term investments totaled $136.5 billion and
$133.8 billion as of June 30, 2020 and 2019. Equity investments were $3.0
billion and $2.6 billion as of June 30, 2020 and 2019, respectively. Our
short-term investments are primarily intended to facilitate liquidity and
capital preservation. They consist predominantly of highly liquid
investment-grade fixed-income securities, diversified among industries and
individual issuers. The investments are predominantly U.S. dollar-denominated
securities, but also include foreign currency-denominated securities to
diversify risk. Our fixed-income investments are exposed to interest rate risk
and credit risk. The credit risk and average maturity of our fixed-income
portfolio are managed to achieve economic returns that correlate to certain
fixed-income indices. The settlement risk related to these investments is
insignificant given that the short-term investments held are primarily highly
liquid investment-grade fixed-income securities.

Valuation


In general, and where applicable, we use quoted prices in active markets for
identical assets or liabilities to determine the fair value of our financial
instruments. This pricing methodology applies to our Level 1 investments, such
as U.S. government securities, common and preferred stock, and mutual funds. If
quoted prices in active markets for identical assets or liabilities are not
available to determine fair value, then we use quoted prices for similar assets
and liabilities or inputs other than the quoted prices that are observable
either directly or indirectly. This pricing methodology applies to our Level 2
investments, such as commercial paper, certificates of deposit, U.S. agency
securities, foreign government bonds, mortgage- and asset-backed securities,
corporate notes and bonds, and municipal securities. Level 3 investments are
valued using internally-developed models with unobservable inputs. Assets and
liabilities measured at fair value on a recurring basis using unobservable
inputs are an immaterial portion of our portfolio.

A majority of our investments are priced by pricing vendors and are generally
Level 1 or Level 2 investments as these vendors either provide a quoted market
price in an active market or use observable inputs for their pricing without
applying significant adjustments. Broker pricing is used mainly when a quoted
price is not available, the investment is not priced by our pricing vendors, or
when a broker price is more reflective of fair values in the market in which the
investment trades. Our broker-priced investments are generally classified as
Level 2 investments because the broker prices these investments based on similar
assets without applying significant adjustments. In addition, all our
broker-priced investments have a sufficient level of trading volume to
demonstrate that the fair values used are appropriate for these investments. Our
fair value processes include controls that are designed to ensure appropriate
fair values are recorded. These controls include model validation, review of key
model inputs, analysis of period-over-period fluctuations, and independent
recalculation of prices where appropriate.

Cash Flows

Fiscal Year 2020 Compared with Fiscal Year 2019


Cash from operations increased $8.5 billion to $60.7 billion for fiscal year
2020, mainly due to an increase in cash from customers, offset in part by an
increase in cash used to pay income taxes, suppliers, and employees. Cash used
in financing increased $9.1 billion to $46.0 billion for fiscal year 2020,
mainly due to a $3.4 billion cash premium on our debt exchange, a $3.4 billion
increase in common stock repurchases, a $1.5 billion increase in repayments of
debt, and a $1.3 billion increase in dividends paid. Cash used in investing
decreased $3.6 billion to $12.2 billion for fiscal year 2020, mainly due to a
$6.4 billion increase in cash from net investment purchases, sales, and
maturities, offset in part by a $1.5 billion increase in additions to property
and equipment and $1.2 billion in other investing to facilitate the purchase of
components.

                                       47
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                                    PART II

                                     Item 7


Fiscal Year 2019 Compared with Fiscal Year 2018


Cash from operations increased $8.3 billion to $52.2 billion for fiscal year
2019, mainly due to an increase in cash received from customers, offset in part
by an increase in cash paid to suppliers and employees and an increase in cash
paid for income taxes. Cash used in financing increased $3.3 billion to $36.9
billion for fiscal year 2019, mainly due to an $8.8 billion increase in common
stock repurchases and a $1.1 billion increase in dividends paid, offset in part
by a $6.2 billion decrease in repayments of debt, net of proceeds from issuance
of debt. Cash used in investing increased $9.7 billion to $15.8 billion for
fiscal year 2019, mainly due to a $6.0 billion decrease in cash from net
investment purchases, sales, and maturities, a $2.3 billion increase in
additions to property and equipment, and a $1.5 billion increase in cash used
for acquisitions of companies, net of cash acquired, and purchases of intangible
and other assets.

Debt

We issue debt to take advantage of favorable pricing and liquidity in the debt
markets, reflecting our credit rating and the low interest rate environment. The
proceeds of these issuances were or will be used for general corporate purposes,
which may include, among other things, funding for working capital, capital
expenditures, repurchases of capital stock, acquisitions, and repayment of
existing debt. In June 2020, we exchanged a portion of our existing debt at
premium for cash and new debt with longer maturities to take advantage of
favorable financing rates in the debt markets, reflecting our credit rating and
the low interest rate environment. Refer to Note 11 - Debt of the Notes to
Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion.

Unearned Revenue


Unearned revenue comprises mainly unearned revenue related to volume licensing
programs, which may include Software Assurance ("SA") and cloud services.
Unearned revenue is generally invoiced annually at the beginning of each
contract period for multi-year agreements and recognized ratably over the
coverage period. Unearned revenue also includes payments for other offerings for
which we have been paid in advance and earn the revenue when we transfer control
of the product or service. Refer to Note 1 - Accounting Policies of the Notes to
Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion.

The following table outlines the expected future recognition of unearned revenue
as of June 30, 2020:



(In millions)


Three Months Ending

September 30, 2020$ 13,884
December 31, 2020       10,950
March 31, 2021           7,476
June 30, 2021            3,690
Thereafter               3,180


Total                 $ 39,180

If our customers choose to license cloud-based versions of our products and services rather than licensing transaction-based products and services, the associated revenue will shift from being recognized at the time of the transaction to being recognized over the subscription period or upon consumption, as applicable.

Share Repurchases


For fiscal years 2020, 2019, and 2018, we repurchased 126 million shares, 150
million shares, and 99 million shares of our common stock for $19.7 billion,
$16.8 billion, and $8.6 billion, respectively, through our share repurchase
programs. All repurchases were made using cash resources. Refer to Note 16 -
Stockholders' Equity of the Notes to Financial Statements (Part II, Item 8 of
this Form 10-K) for further discussion.

Dividends

Refer to Note 16 - Stockholders' Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion.

                                       48

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                                     Item 7


Off-Balance Sheet Arrangements


We provide indemnifications of varying scope and size to certain customers
against claims of intellectual property infringement made by third parties
arising from the use of our products and certain other matters. Additionally, we
have agreed to cover damages resulting from breaches of certain security and
privacy commitments in our cloud business. In evaluating estimated losses on
these obligations, we consider factors such as the degree of probability of an
unfavorable outcome and our ability to make a reasonable estimate of the amount
of loss. These obligations did not have a material impact in our consolidated
financial statements during the periods presented.

Contractual Obligations

The following table summarizes the payments due by fiscal year for our outstanding contractual obligations as of June 30, 2020:




(In millions)                              2021       2022-2023       2024-2025       Thereafter         Total


Long-term debt: (a)
Principal payments                     $  3,750$    10,716$     7,500$     45,441$  67,407
Interest payments                         2,028           3,736           3,293           25,265        34,322
Construction commitments (b)              4,761             280               0                0         5,041
Operating leases, including imputed
interest (c)                              2,420           3,986           2,929            4,409        13,744
Finance leases, including imputed
interest (c)                                992           2,243           2,676            9,611        15,522
Transition tax (d)                        1,450           2,899           6,343            4,531        15,223
Purchase commitments (e)                 25,059           1,324             369              272        27,024
Other long-term liabilities (f)               0             294              32              356           682


Total                                  $ 40,460$    25,478$    23,142$     89,885$ 178,965

(a) Refer to Note 11 - Debt of the Notes to Financial Statements (Part II, Item 8

of this Form 10-K).

(b) Refer to Note 7 - Property and Equipment of the Notes to Financial Statements

(Part II, Item 8 of this Form 10-K).

(c) Refer to Note 14 - Leases of the Notes to Financial Statements (Part II, Item

8 of this Form 10-K).

(d) Refer to Note 12 - Income Taxes of the Notes to Financial Statements (Part

II, Item 8 of this Form 10-K).

(e) Amounts represent purchase commitments, including open purchase orders and

take-or-pay contracts that are not presented as construction commitments

above.

(f) We have excluded long-term tax contingencies, other tax liabilities, and

deferred income taxes of $15.2 billion from the amounts presented as the

timing of these obligations is uncertain. We have also excluded unearned

revenue and non-cash items.

Other Planned Uses of Capital


We will continue to invest in sales, marketing, product support infrastructure,
and existing and advanced areas of technology, as well as continue making
acquisitions that align with our business strategy. Additions to property and
equipment will continue, including new facilities, datacenters, and computer
systems for research and development, sales and marketing, support, and
administrative staff. We expect capital expenditures to increase in coming years
to support growth in our cloud offerings. We have operating and finance leases
for datacenters, corporate offices, research and development facilities, retail
stores, and certain equipment. We have not engaged in any related party
transactions or arrangements with unconsolidated entities or other persons that
are reasonably likely to materially affect liquidity or the availability of
capital resources.

Liquidity


As a result of the TCJA, we are required to pay a one-time transition tax on
deferred foreign income not previously subject to U.S. income tax. Under the
TCJA, the transition tax is payable in interest-free installments over eight
years, with 8% due in each of the first five years, 15% in year six, 20% in year
seven, and 25% in year eight. We have paid transition tax of $3.2 billion, which
included $1.2 billion for fiscal year 2020. The remaining transition tax of
$15.2 billion is payable over the next six years with a final payment in fiscal
year 2026. During fiscal year 2020, we also paid $3.7 billion related to the
transfer of intangible properties that occurred in the fourth quarter of fiscal
year 2019.

                                       49
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                                     Item 7



We expect existing cash, cash equivalents, short-term investments, cash flows
from operations, and access to capital markets to continue to be sufficient to
fund our operating activities and cash commitments for investing and financing
activities, such as dividends, share repurchases, debt maturities, material
capital expenditures, and the transition tax related to the TCJA, for at least
the next 12 months and thereafter for the foreseeable future.

                           RECENT ACCOUNTING GUIDANCE

Refer to Note 1 - Accounting Policies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion.

                  APPLICATION OF CRITICAL ACCOUNTING POLICIES

Our consolidated financial statements and accompanying notes are prepared in
accordance with GAAP. Preparing consolidated financial statements requires
management to make estimates and assumptions that affect the reported amounts of
assets, liabilities, revenue, and expenses. These estimates and assumptions are
affected by management's application of accounting policies, as well as
uncertainty in the current economic environment due to the recent outbreak of
COVID-19. Critical accounting policies for us include revenue recognition,
impairment of investment securities, goodwill, research and development costs,
contingencies, income taxes, and inventories.

Revenue Recognition


Our contracts with customers often include promises to transfer multiple
products and services to a customer. Determining whether products and services
are considered distinct performance obligations that should be accounted for
separately versus together may require significant judgment. When a cloud-based
service includes both on-premises software licenses and cloud services, judgment
is required to determine whether the software license is considered distinct and
accounted for separately, or not distinct and accounted for together with the
cloud service and recognized over time. Certain cloud services, primarily Office
365, depend on a significant level of integration, interdependency, and
interrelation between the desktop applications and cloud services, and are
accounted for together as one performance obligation. Revenue from Office 365 is
recognized ratably over the period in which the cloud services are provided.

Judgment is required to determine the stand-alone selling price ("SSP") for each
distinct performance obligation. We use a single amount to estimate SSP for
items that are not sold separately, including on-premises licenses sold with SA
or software updates provided at no additional charge. We use a range of amounts
to estimate SSP when we sell each of the products and services separately and
need to determine whether there is a discount to be allocated based on the
relative SSP of the various products and services.

In instances where SSP is not directly observable, such as when we do not sell
the product or service separately, we determine the SSP using information that
may include market conditions and other observable inputs. We typically have
more than one SSP for individual products and services due to the stratification
of those products and services by customers and circumstances. In these
instances, we may use information such as the size of the customer and
geographic region in determining the SSP.

Due to the various benefits from and the nature of our SA program, judgment is
required to assess the pattern of delivery, including the exercise pattern of
certain benefits across our portfolio of customers.

Our products are generally sold with a right of return, we may provide other
credits or incentives, and in certain instances we estimate customer usage of
our products and services, which are accounted for as variable consideration
when determining the amount of revenue to recognize. Returns and credits are
estimated at contract inception and updated at the end of each reporting period
if additional information becomes available. Changes to our estimated variable
consideration were not material for the periods presented.

                                       50

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                                     Item 7


Impairment of Investment Securities


We review debt investments quarterly for indicators of other-than-temporary
impairment. This determination requires significant judgment. In making this
judgment, we employ a systematic methodology quarterly that considers available
quantitative and qualitative evidence in evaluating potential impairment of our
investments. If the cost of an investment exceeds its fair value, we evaluate,
among other factors, general market conditions, credit quality of debt
instrument issuers, and the duration and extent to which the fair value is less
than cost. We also evaluate whether we have plans to sell the security or it is
more likely than not that we will be required to sell the security before
recovery. In addition, we consider specific adverse conditions related to the
financial health of and business outlook for the investee, including industry
and sector performance, changes in technology, and operational and financing
cash flow factors. Once a decline in fair value is determined to be
other-than-temporary, an impairment charge is recorded in other income
(expense), net and a new cost basis in the investment is established. If market,
industry, and/or investee conditions deteriorate, we may incur future
impairments.

Equity investments without readily determinable fair values are written down to
fair value if a qualitative assessment indicates that the investment is impaired
and the fair value of the investment is less than carrying value. We perform a
qualitative assessment on a quarterly basis. We are required to estimate the
fair value of the investment to determine the amount of the impairment loss.
Once an investment is determined to be impaired, an impairment charge is
recorded in other income (expense), net.

Goodwill


We allocate goodwill to reporting units based on the reporting unit expected to
benefit from the business combination. We evaluate our reporting units on an
annual basis and, if necessary, reassign goodwill using a relative fair value
allocation approach. Goodwill is tested for impairment at the reporting unit
level (operating segment or one level below an operating segment) on an annual
basis (May 1 for us) and between annual tests if an event occurs or
circumstances change that would more likely than not reduce the fair value of a
reporting unit below its carrying value. These events or circumstances could
include a significant change in the business climate, legal factors, operating
performance indicators, competition, or sale or disposition of a significant
portion of a reporting unit.

Application of the goodwill impairment test requires judgment, including the
identification of reporting units, assignment of assets and liabilities to
reporting units, assignment of goodwill to reporting units, and determination of
the fair value of each reporting unit. The fair value of each reporting unit is
estimated primarily through the use of a discounted cash flow methodology. This
analysis requires significant judgments, including estimation of future cash
flows, which is dependent on internal forecasts, estimation of the long-term
rate of growth for our business, estimation of the useful life over which cash
flows will occur, and determination of our weighted average cost of capital.

The estimates used to calculate the fair value of a reporting unit change from
year to year based on operating results, market conditions, and other factors.
Changes in these estimates and assumptions could materially affect the
determination of fair value and goodwill impairment for each reporting unit.

Research and Development Costs


Costs incurred internally in researching and developing a computer software
product are charged to expense until technological feasibility has been
established for the product. Once technological feasibility is established,
software costs are capitalized until the product is available for general
release to customers. Judgment is required in determining when technological
feasibility of a product is established. We have determined that technological
feasibility for our software products is reached after all high-risk development
issues have been resolved through coding and testing. Generally, this occurs
shortly before the products are released to production. The amortization of
these costs is included in cost of revenue over the estimated life of the
products.

                                       51

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                                     Item 7



Legal and Other Contingencies

The outcomes of legal proceedings and claims brought against us are subject to
significant uncertainty. An estimated loss from a loss contingency such as a
legal proceeding or claim is accrued by a charge to income if it is probable
that an asset has been impaired or a liability has been incurred and the amount
of the loss can be reasonably estimated. In determining whether a loss should be
accrued we evaluate, among other factors, the degree of probability of an
unfavorable outcome and the ability to make a reasonable estimate of the amount
of loss. Changes in these factors could materially impact our consolidated
financial statements.

Income Taxes


The objectives of accounting for income taxes are to recognize the amount of
taxes payable or refundable for the current year, and deferred tax liabilities
and assets for the future tax consequences of events that have been recognized
in an entity's financial statements or tax returns. We recognize the tax benefit
from an uncertain tax position only if it is more likely than not that the tax
position will be sustained on examination by the taxing authorities, based on
the technical merits of the position. The tax benefits recognized in the
financial statements from such a position are measured based on the largest
benefit that has a greater than 50% likelihood of being realized upon ultimate
settlement. Accounting literature also provides guidance on derecognition of
income tax assets and liabilities, classification of deferred income tax assets
and liabilities, accounting for interest and penalties associated with tax
positions, and income tax disclosures. Judgment is required in assessing the
future tax consequences of events that have been recognized in our consolidated
financial statements or tax returns. Variations in the actual outcome of these
future tax consequences could materially impact our consolidated financial
statements.

The TCJA significantly changes existing U.S. tax law and includes numerous provisions that affect our business. Refer to Note 12 - Income Taxes of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion.


Inventories

Inventories are stated at average cost, subject to the lower of cost or net
realizable value. Cost includes materials, labor, and manufacturing overhead
related to the purchase and production of inventories. Net realizable value is
the estimated selling price less estimated costs of completion, disposal, and
transportation. We regularly review inventory quantities on hand, future
purchase commitments with our suppliers, and the estimated utility of our
inventory. These reviews include analysis of demand forecasts, product life
cycle status, product development plans, current sales levels, pricing strategy,
and component cost trends. If our review indicates a reduction in utility below
carrying value, we reduce our inventory to a new cost basis through a charge to
cost of revenue.

                         CHANGE IN ACCOUNTING ESTIMATE

In July 2020, we completed an assessment of the useful lives of our server and
network equipment and determined we should increase the estimated useful life of
server equipment from three years to four years and increase the estimated
useful life of network equipment from two years to four years. This change in
accounting estimate will be effective beginning fiscal year 2021. Based on the
carrying amount of server and network equipment included in "Property and
equipment, net" as of June 30, 2020, it is estimated this change will increase
our fiscal year 2021 operating income by $2.7 billion.



                                       52

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                                    PART II

                                     Item 7


STATEMENT OF MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL STATEMENTS

Management is responsible for the preparation of the consolidated financial statements and related information that are presented in this report. The consolidated financial statements, which include amounts based on management's estimates and judgments, have been prepared in conformity with accounting principles generally accepted in the United States of America.


The Company designs and maintains accounting and internal control systems to
provide reasonable assurance at reasonable cost that assets are safeguarded
against loss from unauthorized use or disposition, and that the financial
records are reliable for preparing consolidated financial statements and
maintaining accountability for assets. These systems are augmented by written
policies, an organizational structure providing division of responsibilities,
careful selection and training of qualified personnel, and a program of internal
audits.

The Company engaged Deloitte & Touche LLP, an independent registered public
accounting firm, to audit and render an opinion on the consolidated financial
statements and internal control over financial reporting in accordance with the
standards of the Public Company Accounting Oversight Board (United States).

The Board of Directors, through its Audit Committee, consisting solely of independent directors of the Company, meets periodically with management, internal auditors, and our independent registered public accounting firm to ensure that each is meeting its responsibilities and to discuss matters concerning internal controls and financial reporting. Deloitte & Touche LLP and the internal auditors each have full and free access to the Audit Committee.




Satya Nadella
Chief Executive Officer

Amy E. Hood
Executive Vice President and Chief Financial Officer

Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer




                                       53
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                                    PART II

                                    Item 7A

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10/25Samsung Heir Takes Reins of Tech Giant Stuck in His Father's Past
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