Microsoft 2012 Annual Report Download - page 47

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, net of estimated forfeitures, 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. Deferred tax assets are reported net of a valuation
allowance when it is more likely than not that a tax benefit will not be realized. 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 and goodwill when it is recorded at
fair value due to an impairment charge. 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. 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. Unobservable inputs used in all of these models are significant to
the fair values of the assets and liabilities.