Microsoft 2004 Annual Report Download - page 29

PAGE 29
APPLICATION OF CRITICAL ACCOUNTING POLICIES
Our financial statements and accompanying notes are prepared in accordance with U.S. GAAP. Preparing 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. Critical accounting policies for us include revenue recognition, impairment of investment securities,
impairment of goodwill, accounting for research and development costs, accounting for legal contingencies, and
accounting for income taxes.
We account for the licensing of software in accordance with American Institute of Certified Public Accountants (AICPA)
Statement of Position (SOP) 97-2, Software Revenue Recognition. The application of SOP 97-2 requires judgment,
including whether a software arrangement includes multiple elements, and if so, whether vendor-specific objective
evidence (VSOE) of fair value exists for those elements. Customers receive certain elements of our products over a
period of time. These elements include free post-delivery telephone support and the right to receive unspecified
upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis, the fair value of which is
recognized over the product’s estimated life cycle. Changes to the elements in a software arrangement, the ability to
identify VSOE for those elements, the fair value of the respective elements, and changes to a product’s estimated life
cycle could materially impact the amount of earned and unearned revenue. Judgment is also required to assess whether
future releases of certain software represent new products or upgrades and enhancements to existing products.
SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, and Securities and Exchange
Commission (SEC) Staff Accounting Bulletin (SAB) 59, Accounting for Noncurrent Marketable Equity Securities, provide
guidance on determining when an investment is other-than-temporarily impaired. Investments are reviewed quarterly for
indicators of other-than-temporary impairment. This determination requires significant judgment. In making this judgment,
we evaluate, among other factors, the duration and extent to which the fair value of an investment is less than its cost; the
financial health of and near-term business outlook for the investee, including factors such as industry and sector
performance, changes in technology, and operational and financing cash flow; and our intent and ability to hold the
investment. Investments with an indicator are further evaluated to determine the likelihood of a significant adverse affect
on the fair value and amount of the impairment as necessary. In the past, we have had substantial impairments in our
portfolio as discussed in Note 4 – Investment Income/(Loss). If market, industry and/or investee conditions deteriorate, we
may incur future impairments.
SFAS 142, Goodwill and Other Intangible Assets, requires that goodwill be tested for impairment at the reporting unit
level (operating segment or one level below an operating segment) on an annual basis (July 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, 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 using a discounted cash flow methodology. This
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, the useful life over which cash flows will occur, and
determination of our weighted average cost of capital. Changes in these estimates and assumptions could materially
affect the determination of fair value and/or goodwill impairment for each reporting unit.
We account for research and development costs in accordance with several accounting pronouncements, including
SFAS 2, Accounting for Research and Development Costs, and SFAS 86, Accounting for the Costs of Computer Software
to be Sold, Leased, or Otherwise Marketed. SFAS 86 specifies that costs incurred internally in researching and
developing a computer software product should be charged to expense until technological feasibility has been established
for the product. Once technological feasibility is established, all software costs should be 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 shortly before the
products are released to manufacturing. Costs incurred after technological feasibility is established are not material, and
accordingly, we expense all research and development costs when incurred.
The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. SFAS 5,
Accounting for Contingencies, requires that an estimated loss from a loss contingency such as a legal proceeding or claim
should be 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. Disclosure of a contingency is required if there is at least a
reasonable possibility that a loss has been incurred. 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 financial position or our results of operations.