Microsoft 2009 Annual Report Download - page 56

PAGE 56
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
• Level 2 – inputs are based upon quoted prices for similar instruments in active markets, quoted prices for
identical or similar instruments in markets that are not active, and model-based valuation techniques for which
all significant assumptions are observable in the market or can be corroborated by observable market data for
substantially the full term of the assets or liabilities.
• Level 3 – inputs are generally unobservable and typically reflect management’s estimates of assumptions that
market participants would use in pricing the asset or liability. The fair values are therefore determined using
model-based techniques that include option pricing models, discounted cash flow models, and similar
techniques.
The following section describes the valuation methodologies we use to measure financial assets and liabilities at
fair value.
INVESTMENTS OTHER THAN DERIVATIVES
Investments other than derivatives primarily include U.S. Government and Agency securities, foreign government
bonds, mortgage-backed securities, commercial paper, corporate notes and bonds, and common and preferred
stock.
In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to
determine fair value. This pricing methodology applies to our Level 1 investments, such as domestic and
international equities, U.S. treasuries, exchange-traded mutual funds, and agency securities. 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. These investments are included in Level 2 and consist primarily of corporate notes and bonds, foreign
government bonds, mortgage-backed securities, commercial paper, and certain agency securities. Our Level 3
assets primarily include investments in certain corporate bonds. We value the Level 3 corporate bonds using
internally developed valuation models, inputs to which include interest rate curves, credit spreads, stock prices, and
volatilities. Unobservable inputs used in these models are significant to the fair values of the investments.
DERIVATIVES
In general, and where applicable, we use quoted prices in an active market for identical derivative assets and
liabilities that are traded on exchanges. These derivative assets and liabilities are included in Level 1. The fair values
for the derivative assets and liabilities included in Level 2 are estimated using industry standard valuation models,
such as the Black-Scholes model. Where applicable, these models project future cash flows and discount the future
amounts to a present value using market-based observable inputs including interest rate curves, foreign exchange
rates, and forward and spot prices for currencies and commodities. Level 2 derivative assets and liabilities primarily
include certain over-the-counter options, futures, and swap contracts. In certain cases, market-based observable
inputs are not available and we use management judgment to develop assumptions to determine fair value. These
derivative assets and liabilities are included in Level 3 and primarily represent derivatives for foreign equities.