Microsoft 2007 Annual Report Download - page 39

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NOTES TO FINANCIAL STATEMENTS (CONTINUED)
and Microsoft Developer Network subscriptions are also accounted for as subscriptions.
Revenue related to our Xbox game console and other hardware components is recognized upon shipment of
the product to retailers. Revenue related to games published by us is recognized when those games have been
delivered to retailers. Revenue related to games published by third parties for use on the Xbox platform is
recognized when manufactured for the game publishers. Online advertising revenue is recognized as
advertisements are displayed. Search advertising revenue is recognized when the ad appears in the search
results or when the action necessary to earn the revenue has been completed. Consulting services revenue is
recognized as services are rendered, generally based on the negotiated hourly rate in the consulting arrangement
and the number of hours worked during the period. Consulting revenue for fixed-price services arrangements is
recognized based on percentage of completion.
Costs related to insignificant obligations, which include telephone support for developer tools software, PC
games, computer hardware, and Xbox, are accrued when the related revenue is recognized. Provisions are
recorded for estimated returns, concessions, warranties, and bad debts.
COST OF REVENUE
Cost of revenue includes manufacturing and distribution costs for products sold and programs licensed, operating
costs related to product support service centers and product distribution centers, costs incurred to support and
maintain Internet-based products and services, warranty costs, inventory write-downs, costs associated with the
delivery of consulting services, and the amortization of capitalized research and development costs associated
with software products that have reached technological feasibility.
RESEARCH AND DEVELOPMENT
Research and development expenses include payroll, employee benefits, stock-based compensation, and other
headcount-related costs associated with product development. We have determined that technological feasibility
for our software products is reached shortly before the products are released to manufacturing. The amortization
of these costs is included in cost of revenue over the estimated life of the products. 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. Previously, costs incurred prior to technological feasibility were not material and were expensed as
incurred.
SALES AND MARKETING
Sales and marketing expenses include payroll, employee benefits, stock-based compensation, and other
headcount-related costs associated with sales and marketing personnel and advertising, promotions, tradeshows,
seminars, and other marketing-related programs. Advertising costs are expensed as incurred. Advertising
expense was $1.33 billion, $1.23 billion, and $995 million in fiscal years 2007, 2006, and 2005, respectively.
INCOME TAXES
Income tax expense includes U.S. and international income taxes, plus the provision for U.S. taxes on
undistributed earnings of international subsidiaries not deemed to be permanently invested. Certain items of
income and expense are not reported in tax returns and financial statements in the same year. The tax effect of
such temporary differences is reported as deferred income taxes.
FINANCIAL INSTRUMENTS
We consider all highly liquid interest-earning investments with a maturity of three months or less at the date of
purchase to be cash equivalents. The fair value of these investments approximates their carrying value. In
general, investments with original maturities of greater than three months and remaining maturities of less than
one year are classified as short-term investments. Investments with maturities beyond one year may be classified
as short-term based on their highly liquid nature and because such marketable securities represent the
investment of cash that is available for current operations. All cash equivalents and short-term investments are
classified as available for sale and are recorded at market value using the specific identification method. Changes
in market value are reflected in OCI (excluding other-than-temporary impairments).