Microsoft 2007 Annual Report Download - page 31

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
to be other-than-temporary, an impairment charge is recorded and a new cost basis in the investment is
established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments.
SFAS No. 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 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 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 allocate goodwill to reporting units based on the
reporting unit expected to benefit from the combination. We evaluate our reporting units on an annual basis and, if
necessary, reassign goodwill using a relative fair value allocation approach.
We account for research and development costs in accordance with applicable accounting pronouncements,
including SFAS No. 2, Accounting for Research and Development Costs, and SFAS No. 86, Accounting for the
Costs of Computer Software to be Sold, Leased, or Otherwise Marketed. SFAS No. 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 after all high-risk development issues have been
resolved through coding and testing. This is generally shortly before the products are released to manufacturing.
We determined that technological feasibility was reached with Windows Vista and the 2007 Microsoft Office
system during the second quarter of fiscal year 2007 and accordingly, we capitalized approximately $120 million
of software development costs. The amortization of these costs will be included in cost of revenue over the
estimated life of the products. Previously, costs incurred prior to technological feasibility were not material and
were expensed as incurred.
The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty.
SFAS No. 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 results of operations, financial position, or our cash flows.
SFAS No. 109, Accounting for Income Taxes, establishes financial accounting and reporting standards for the
effect of 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. Judgment is required in
assessing the future tax consequences of events that have been recognized in our financial statements or tax
returns. Variations in the actual outcome of these future tax consequences could materially impact our financial
position, results of operations, or cash flows. Accruals for tax contingencies are provided for in accordance with
the requirements of SFAS No. 5.
We account for stock-based compensation in accordance with SFAS No. 123(R), Share-Based Payment.
Under the fair value recognition provisions of this statement, share-based compensation cost is measured at the
grant date based on the fair value of the award and is recognized as expense over the requisite service period.
Determining the fair value of share-based awards at the grant date requires judgment, including estimating
expected dividends. In addition, judgment is also required in estimating the amount of share-based awards that
are expected to be forfeited. If actual results differ significantly from these estimates, stock-based compensation
expense and our results of operations could be materially impacted.