MICROSOFT CORPORATION 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). This section generally discusses
the results of our operations for the year ended June 30, 2021 compared to the
year ended June 30, 2020 . For a discussion of the year ended June 30, 2020
compared to the year ended June 30, 2019 , please refer to Part II, Item 7,
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" in our Annual Report on Form 10-K for the year ended June 30, 2020 .
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 continues to respond to 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 2021 compared with fiscal year 2020 included:
• Commercial cloud revenue increased 34% to
• Office Commercial products and cloud services revenue increased 13% driven
by Office 365 Commercial growth of 22%.
• Office Consumer products and cloud services revenue increased 10% and
Microsoft 365 Consumer subscribers increased to 51.9 million. • LinkedIn revenue increased 27%. • Dynamics products and cloud services revenue increased 25% driven by Dynamics 365 growth of 43%.
• Server products and cloud services revenue increased 27% driven by Azure
growth of 50%.
• Windows original equipment manufacturer licensing ("Windows OEM") revenue
increased slightly.
• Windows Commercial products and cloud services revenue increased 14%.
• Xbox content and services revenue increased 23%.
• Search advertising revenue, excluding traffic acquisition costs, increased
13%.
• Surface revenue increased 5%.
On March 9, 2021 , we completed our acquisition of ZeniMax Media Inc.
("ZeniMax"), the parent company of Bethesda Softworks LLC , for a total purchase
price of $8.1 billion , consisting primarily of cash. The purchase price included
$768 million of cash and cash equivalents acquired. The financial results of
ZeniMax have been included in our consolidated financial statements since the
date of the acquisition. ZeniMax is reported as part of our More Personal
Computing segment. Refer to Note 8 - Business Combinations of the Notes to
Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion.
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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.
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 devices are primarily manufactured by third-party contract manufacturers, some of which contain certain components for which there are very few qualified suppliers. For these components, we have limited near-term flexibility to use other manufacturers if a current vendor becomes unavailable or is unable to meet our requirements. Extended disruptions at these suppliers could lead to a similar disruption in our ability to manufacture devices on time to meet consumer demand. 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 theU.S. dollar. As a result, changes in foreign exchange rates may significantly affect revenue and expenses. Weakening of theU.S. dollar relative to certain foreign currencies increased reported revenue and did not have a material impact on reported expenses from our international operations in fiscal year 2021.
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 2021, the COVID-19 pandemic continued to impact our business operations and financial results. Cloud usage and demand benefited as customers accelerate their digital transformation priorities. Our consumer businesses also benefited from the remote environment, with continued demand for PCs and productivity tools, as well as strong engagement across our Gaming platform. We saw improvement in customer advertising spend and savings in operating expenses related to COVID-19, but experienced weakness in transactional licensing. The COVID-19 pandemic may continue to impact our business operations and financial operating results, and there is uncertainty in the nature and degree of its continued effects over time. 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.
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Change in Accounting Estimate
InJuly 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 was effective beginning fiscal year 2021. Based on the carrying amount of server and network equipment included in property and equipment, net as ofJune 30, 2020 , the effect of this change in estimate for fiscal year 2021 was an increase in operating income of$2.7 billion and net income of$2.3 billion , or$0.30 per both basic and diluted share.
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 inthe 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 Azure, Office 365 Commercial, 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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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 (Office 365 subscriptions, the
Office 365
portion of
subscriptions, and Office licensed on-premises),
comprising Office, Exchange, SharePoint,
Microsoft
Teams, Office 365 Security and
Compliance,
and
Office Consumer products and cloud services revenue growth Revenue from Office Consumer products and cloud
services,
including
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
Microsoft 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, comprising a
set of intelligent, cloud-based applications
across ERP, CRM, Customer Insights, Power Apps,
and Power Automate; and on-premises ERP and CRM
applications
LinkedIn revenue growth Revenue from LinkedIn, including Talent
Solutions,Marketing Solutions, Premium
Subscriptions, Sales Solutions, and Learning
Solutions
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 Client
Access Licenses ("CALs"); and GitHub
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
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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
digital transactions,
and other subscriptions, video games,
third-party video game royalties, cloud
services, and advertising
Search advertising revenue, excluding TAC, growth Revenue from search advertising excluding
traffic acquisition costs ("TAC") paid to Bing
Ads network publishers
SUMMARY RESULTS OF OPERATIONS
Percentage(In millions, except percentages and per share amounts) 2021
2020 Change Revenue$ 168,088 $ 143,015 18% Gross margin 115,856 96,937 20% Operating income 69,916 52,959 32% Net income 61,271 44,281 38% Diluted earnings per share 8.05 5.76 40% Adjusted net income (non-GAAP) 60,651 44,281 37% Adjusted diluted earnings per share (non-GAAP) 7.97 5.76 38% Adjusted net income and adjusted diluted earnings per share ("EPS") are non-GAAP financial measures which exclude tax benefits related to anIndia Supreme Court decision on withholding taxes in fiscal year 2021. 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. See Note 12 - Income Taxes of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion.
Revenue increased
Cost of revenue increased$6.2 billion or 13% driven by growth in commercial cloud and Gaming, offset in part by a reduction in depreciation expense due to the change in estimated useful lives of our server and network equipment. Gross margin increased$18.9 billion or 20% driven by growth across each of our segments and the change in estimated useful lives of our server and network equipment. Gross margin percentage increased with the change in estimated useful lives of our server and network equipment. Excluding this impact, gross margin percentage decreased slightly driven by gross margin percentage reduction in More Personal Computing. Commercial cloud gross margin percentage increased 4 points to 71% driven by gross margin percentage improvement in Azure and the change in estimated useful lives of our server and network equipment, offset in part by sales mix shift to Azure. Operating expenses increased$2.0 billion or 4% driven by investments in cloud engineering and commercial sales, offset in part by savings related to COVID-19 across each of our segments, prior year charges associated with the closing of ourMicrosoft Store physical locations, and a reduction in bad debt expense.
Key changes in operating expenses were:
• Research and development expenses increased
investments in cloud engineering.
• Sales and marketing expenses increased
investments in commercial sales, offset in part by a reduction in bad debt
expense. Sales and marketing included an unfavorable foreign currency
impact of 2%.
• General and administrative expenses were relatively unchanged, driven by
prior year charges associated with the closing of our
physical locations, offset in part by an increase in certain
employee-related expenses and business taxes.
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Operating income increased $17.0 billion or 32% driven by growth across each of
our segments and the change in estimated useful lives of our server and network
equipment.
Current year net income and diluted EPS were positively impacted by the tax
benefit related to the India Supreme Court decision on withholding taxes, which
resulted in an increase to net income and diluted EPS of $620 million and $0.08 ,
respectively.
Revenue, gross margin, and operating income included a favorable foreign currency impact of 3%, 3%, and 4%, respectively.
SEGMENT RESULTS OF OPERATIONS
Percentage(In millions, except percentages) 2021 2020 Change
Revenue Productivity and Business Processes$ 53,915 $ 46,398 16% Intelligent Cloud 60,080 48,366 24% More Personal Computing 54,093 48,251 12% Total$ 168,088 $ 143,015 18% Operating Income Productivity and Business Processes$ 24,351 $ 18,724 30% Intelligent Cloud 26,126 18,324 43% More Personal Computing 19,439 15,911 22% Total$ 69,916 $ 52,959 32% Reportable Segments
Productivity and Business Processes
Revenue increased
• Office Commercial products and cloud services revenue increased
billion or 13%. Office 365 Commercial revenue grew 22% driven by seat
growth of 17% and higher revenue per user. Office Commercial products
revenue declined 23% driven by continued customer shift to cloud offerings
and transactional weakness.
• Office Consumer products and cloud services revenue increased
or 10% driven by Microsoft 365 Consumer subscription revenue, on a strong
prior year comparable that benefited from transactional strength in Japan .
Microsoft 365 Consumer subscribers increased 22% to 51.9 million.
• LinkedIn revenue increased
demand in our Marketing Solutions business.
• Dynamics products and cloud services revenue increased 25% driven by
Dynamics 365 growth of 43%.
Operating income increased
• Gross margin increased
Commercial and LinkedIn, and the change in estimated useful lives of our
server and network equipment. Gross margin percentage increased with the
change in estimated useful lives of our server and network equipment.
Excluding this impact, gross margin percentage decreased slightly driven
by a sales mix shift to cloud offerings, on a low prior year comparable
impacted by increased usage.
• Operating expenses increased
commercial sales, cloud engineering, and LinkedIn.
Revenue, gross margin, and operating income included a favorable foreign currency impact of 2%, 3%, and 4%, respectively.
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Intelligent Cloud
Revenue increased
• Server products and cloud services revenue increased
driven by Azure. Azure revenue grew 50% due to growth in our
consumption-based services. Server products revenue increased 6% driven by
hybrid and premium solutions, on a strong prior year comparable that
benefited from demand related to SQL Server 2008 and Windows Server 2008
end of support.
• Enterprise Services revenue increased
in
Operating income increased
• Gross margin increased
the change in estimated useful lives of our server and network equipment.
Gross margin percentage increased with the change in estimated useful
lives of our server and network equipment. Excluding this impact, gross
margin percentage was relatively unchanged driven by gross margin
percentage improvement in Azure, offset in part by sales mix shift to
Azure.
• Operating expenses increased
Azure.
Revenue, gross margin, and operating income included a favorable foreign currency impact of 2%, 3%, and 4%, respectively.
More Personal Computing
Revenue increased
• Windows revenue increased
Commercial. Windows Commercial products and cloud services revenue
increased 14% driven by demand for
increased slightly driven by consumer PC demand, on a strong prior year
OEM Pro comparable that benefited from Windows 7 end of support. Windows
OEM Pro revenue decreased 9% and Windows OEM non-Pro revenue grew 21%.
• Gaming revenue increased $3.8 billion or 33% driven by growth in Xboxcontent and services and Xbox hardware. Xbox content and services revenue
increased
increased 92% driven by higher price of consoles sold due to the Xbox
Series X|S launches.
• Search advertising revenue increased $788 million or 10%. Search
advertising revenue excluding traffic acquisition costs increased 13%
driven by higher revenue per search and search volume.
• Surface revenue increased $302 million or 5%.
Operating income increased
• Gross margin increased
Gaming, and Search advertising. Gross margin percentage decreased driven
by sales mix shift to Gaming hardware.
• Operating expenses decreased
charges associated with the closing of our
locations and reductions in retail store expenses and marketing, offset in
part by investments in Gaming.
Gross margin and operating income included a favorable foreign currency impact of 2% and 3%, respectively.
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OPERATING EXPENSES
Research and Development
Percentage
(In millions, except percentages) 2021 2020 Change
Research and development $ 20,716 $ 19,269 8%
As a percent of revenue 12% 13% (1)ppt
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.
Research and development expenses increased
Sales and Marketing
Percentage
(In millions, except percentages) 2021 2020 Change
Sales and marketing
$ 20,117 $ 19,598 3%
As a percent of revenue 12% 14% (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.
Sales and marketing expenses increased $519 million or 3% driven by investments
in commercial sales, offset in part by a reduction in bad debt expense. Sales
and marketing included an unfavorable foreign currency impact of 2%.
General and Administrative
Percentage
(In millions, except percentages) 2021 2020 Change
General and administrative $ 5,107 $ 5,111 0%
As a percent of revenue 3% 4% (1)ppt
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.
General and administrative expenses were relatively unchanged, driven by prior
year charges associated with the closing of our Microsoft Store physical
locations, offset in part by an increase in certain employee-related expenses
and business taxes.
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OTHER INCOME (EXPENSE), NET
The components of other income (expense), net were as follows:
(In millions) Year Ended June 30, 2021 2020 Interest and dividends income$ 2,131 $
2,680
Interest expense (2,346 ) (2,591 ) Net recognized gains on investments 1,232
32
Net gains on derivatives 17
187
Net gains (losses) on foreign currency remeasurements 54 (191 ) Other, net 98 (40 ) Total$ 1,186 $ 77
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.
Interest and dividends income decreased due to lower yields on fixed-income securities. Interest expense decreased due to a decrease in outstanding long-term debt due to debt maturities. Net recognized gains on investments increased due to higher gains on equity securities. Net gains on derivatives decreased due to lower gains on foreign currency contracts.
INCOME TAXESEffective Tax Rate
Our effective tax rate for fiscal years 2021 and 2020 was 14% and 17%, respectively. The decrease in our effective tax rate was primarily due to tax benefits from a decision by theIndia Supreme Court on withholding taxes in the case ofEngineering Analysis Centre of Excellence Private Limited vs The Commissioner of Income Tax, an agreement between theU.S. andIndia tax authorities related to transfer pricing, final Tax Cuts and Jobs Act ("TCJA") regulations, and an increase in tax benefits relating to stock-based compensation. We have historically paidIndia withholding taxes on software sales through distributor withholding and tax audit assessments inIndia . InMarch 2021 , theIndia Supreme Court ruled favorably for companies in 86 separate appeals, some dating back to 2012, holding that software sales are not subject toIndia withholding taxes. Although we were not a party to the appeals, our software sales inIndia were determined to be not subject to withholding taxes. Therefore, we recorded a net income tax benefit of$620 million in the third quarter of fiscal year 2021 to reflect the results of theIndia Supreme Court decision impacting fiscal year 1996 through fiscal year 2016. Our effective tax rate was lower than theU.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 inIreland andPuerto Rico , tax benefits relating to stock-based compensation, and tax benefits from theIndia Supreme Court decision on withholding taxes. The mix of income before income taxes between theU.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 2021, ourU.S. income before income taxes was$35.0 billion and our foreign income before income taxes was$36.1 billion . In fiscal year 2020, ourU.S. income before income taxes was$24.1 billion and our foreign income before income taxes was$28.9 billion . Uncertain Tax Positions We settled a portion of the Internal Revenue Service ("IRS") audit for tax years 2004 to 2006 in fiscal year 2011. InFebruary 2012 , theIRS 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 theIRS audit for tax years 2007 to 2009 in fiscal year 2016, and a portion of theIRS audit for tax years 2010 to 2013 in fiscal year 2018. In the second quarter of fiscal year 2021, we settled an additional portion of theIRS audits for tax years 2004 to 2013 and made a payment of$1.7 billion , including tax and interest. We remain under audit for tax years 2004 to 2017. 47 --------------------------------------------------------------------------------
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As of June 30, 2021 , 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 key transfer pricing 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 2020, 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
Adjusted net income and adjusted diluted EPS are non-GAAP financial measures
which exclude the tax benefits related to the India Supreme Court decision on
withholding taxes in fiscal year 2021. 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:
(In millions, except percentages and per Percentage share amounts) 2021 2020 Change Net income$ 61,271 $ 44,281 38% Net income tax benefit related toIndia Supreme Court decision on withholding taxes (620 ) 0 * Adjusted net income (non-GAAP)$ 60,651 $ 44,281 37% Diluted earnings per share$ 8.05 $ 5.76 40% Net income tax benefit related toIndia Supreme Court decision on withholding taxes (0.08 ) 0 * Adjusted diluted earnings per share (non-GAAP)$ 7.97 $ 5.76 38% * Not meaningful. 48
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FINANCIAL CONDITION
Cash, Cash Equivalents, and Investments
Cash, cash equivalents, and short-term investments totaled$130.3 billion and$136.5 billion as ofJune 30, 2021 and 2020. Equity investments were$6.0 billion and$3.0 billion as ofJune 30, 2021 and 2020, 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 predominantlyU.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 asU.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
Cash from operations increased$16.1 billion to$76.7 billion for fiscal year 2021, mainly due to an increase in cash received from customers, offset in part by an increase in cash paid to suppliers and employees. Cash used in financing increased$2.5 billion to$48.5 billion for fiscal year 2021, mainly due to a$4.4 billion increase in common stock repurchases and a$1.4 billion increase in dividends paid, offset in part by a$1.8 billion decrease in repayments of debt and a$1.7 billion decrease in cash premium paid on debt exchange. Cash used in investing increased$15.4 billion to$27.6 billion for fiscal year 2021, mainly due to a$6.4 billion increase in cash used for acquisitions of companies, net of cash acquired, and purchases of intangible and other assets, a$5.2 billion increase in additions to property and equipment, and a$4.1 billion decrease in cash from net investment purchases, sales, and maturities.
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. InMarch 2021 andJune 2020 , we exchanged a portion of our existing debt at a 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. 49 --------------------------------------------------------------------------------
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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, 2021 :
(In millions)
Three Months Ending
September 30, 2021 $ 15,922
December 31, 2021 12,646
March 31, 2022 8,786
June 30, 2022 4,171
Thereafter 2,616
Total $ 44,141 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
During fiscal years 2021 and 2020, we repurchased 101 million shares and 126 million shares of our common stock for$23.0 billion and$19.7 billion , respectively, through our share repurchase programs. All repurchases were made using cash resources. Refer to Note 16 - Stockholders' Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion.
Dividends
Refer to Note 16 - Stockholders' Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion.
Off-Balance Sheet Arrangements
We provide indemnifications of varying scope and size to certain customers
against claims of intellectual property infringement made by third parties
arising from the use of our products and certain other matters. Additionally, we
have agreed to cover damages resulting from breaches of certain security and
privacy commitments in our cloud business. In evaluating estimated losses on
these obligations, we consider factors such as the degree of probability of an
unfavorable outcome and our ability to make a reasonable estimate of the amount
of loss. These obligations did not have a material impact in our consolidated
financial statements during the periods presented.
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Contractual Obligations
The following table summarizes the payments due by fiscal year for our
outstanding contractual obligations as of
(In millions) 2022 2023-2024 2025-2026 Thereafter Total Long-term debt: (a) Principal payments$ 8,075 $ 8,000 $ 5,250 $ 42,585 $ 63,910 Interest payments 1,628 2,847 2,438 17,320 24,233 Construction commitments (b) 8,927 529 0 0 9,456 Operating leases, including 2,801 4,956 3,469 6,747 17,973 imputed interest (c) Finance leases, including 1,341 3,256 3,774 14,096 22,467 imputed interest (c) Transition tax (d) 1,427 4,105 8,030 0 13,562 Purchase commitments (e) 29,129 1,708 446 270 31,553 Other long-term liabilities (f) 0 365 68 263 696 Total$ 53,328 $ 25,766 $ 23,475 $ 81,281 $ 183,850
(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
timing of these obligations is uncertain. We have also excluded unearned
revenue and non-cash items.
Other Planned Uses of Capital
OnApril 11, 2021 , we entered into a definitive agreement to acquire Nuance Communications, Inc. ("Nuance") for$56.00 per share in an all-cash transaction valued at$19.7 billion , inclusive of Nuance's net debt. The acquisition has been approved by Nuance's shareholders, and we expect it to close by the end of calendar year 2021, subject to the satisfaction of certain regulatory approvals and other customary closing conditions. 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,Microsoft Experience Centers, 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 toU.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$4.7 billion , which included$1.5 billion for fiscal year 2021. The remaining transition tax of$13.6 billion is payable over the next five years with a final payment in fiscal year 2026. 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. 51 --------------------------------------------------------------------------------
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Item 7
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 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.
Impairment of
We review debt investments quarterly for credit losses and impairment. 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
extent to which the fair value is less than cost. This determination requires
significant judgment. In making this judgment, we employ a systematic
methodology that considers available quantitative and qualitative evidence in
evaluating potential impairment of our investments. In addition, we consider
specific adverse conditions related to the financial health of, and business
outlook for, the investee. If 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,
then a decline in fair value below cost is recorded as an impairment charge 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.
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Item 7
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 periodic 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.
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.
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The TCJA significantly changes existing
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.
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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 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 engagedDeloitte & 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 thePublic 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.
Satya Nadella Chief Executive OfficerAmy E. Hood Executive Vice President and Chief Financial OfficerAlice L. Jolla Corporate Vice President and Chief Accounting Officer 55
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Item 7A© Edgar Online, source
