Microsoft 2011 Annual Report Download - page 47

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Stock-Based Compensation
We measure stock-based compensation cost at the grant date based on the fair value of the award and recognize
it as expense over the vesting or service period, as applicable, of the stock award (generally four to five years)
using the straight-line method.
Employee Stock Purchase Plan
Shares of our common stock may be purchased by employees at three-month intervals at 90% of the fair market
value of the stock on the last day of each three-month period. Compensation expense for the employee stock
purchase plan is measured as the discount the employee is entitled to upon purchase and is recognized in the
period of purchase.
Income Taxes
Income tax expense includes U.S. and international income taxes, the provision for U.S. taxes on undistributed
earnings of international subsidiaries not deemed to be permanently invested, and interest and penalties on
uncertain tax positions. Certain income and expenses 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. The deferred
income taxes are classified as current or long-term based on the classification of the related asset or liability.
Fair Value Measurements
We account for certain assets and liabilities at fair value. The hierarchy below lists three levels of fair value based
on the extent to which inputs used in measuring fair value are observable in the market. We categorize each of
our fair value measurements in one of these three levels based on the lowest level input that is significant to the
fair value measurement in its entirety. These levels are:
• Level 1 – inputs are based upon unadjusted quoted prices for identical instruments traded in active
markets. Our Level 1 non-derivative investments primarily include U.S. treasuries, domestic and
international equities, and actively traded mutual funds. Our Level 1 derivative assets and liabilities
include those actively traded on exchanges.
• 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 (e.g. the Black-Scholes model) for which all significant inputs are observable in the market
or can be corroborated by observable market data for substantially the full term of the assets or
liabilities. 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. Our Level 2 non-derivative
investments consist primarily of corporate notes and bonds, mortgage-backed securities, agency
securities, certificates of deposit, and commercial paper. Our Level 2 derivative assets and liabilities
primarily include certain over-the-counter option and swap contracts.
• 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, including option pricing models and discounted
cash flow models. Our Level 3 non-derivative assets primarily comprise investments in certain
corporate bonds. We value these 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. Our Level 3 derivative assets
and liabilities primarily comprise derivatives for foreign equities. In certain cases, market-based
observable inputs are not available and we use management judgment to develop assumptions to
determine fair value for these derivatives.
We measure certain assets, including our cost and equity method investments, at fair value on a nonrecurring
basis when they are deemed to be other-than-temporarily impaired. The fair values of these investments are
determined based on valuation techniques using the best information available, and may include quoted market
prices, market comparables, and discounted cash flow projections. An impairment charge is recorded when the
cost of the investment exceeds its fair value and this condition is determined to be other-than-temporary.