RESULTS OF OPERATIONS FOR FISCAL YEARS 2003, 2004, AND 2005

OVERVIEW

The following Management’s Discussion and Analysis (MD&A) is intended to help the reader understand the results of operations and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with our financial statements and the accompanying notes to the financial statements (Notes).

We develop, manufacture, license, and support a wide range of software products for many computing devices. Our software products include operating systems for servers, PCs, and intelligent devices; server applications for distributed computing environments; information worker productivity applications; business solutions applications; and software development tools. We provide consulting and product support services, and we train and certify system integrators and developers. We sell the Xbox video game console and games, PC games, and PC peripherals. Online communication and information services are delivered through our MSN portals and channels around the world.

Our revenue historically has fluctuated quarterly and has generally been the highest in the second quarter of our fiscal year due to corporate calendar year-end spending trends in our major markets and holiday season spending by consumers. Our Home and Entertainment segment is particularly subject to seasonality as its products are aimed at the consumer market and are in highest demand during the holiday shopping season. Historically, approximately 40% to 50% of Home and Entertainment revenue has been generated in the second fiscal quarter. We believe the seasonality of revenue is likely to continue in the future.

We intend to sustain the long-term growth of our businesses through technological innovation, engineering excellence, and a commitment to delivering high-quality products and services to customers and partners. Recognizing that one of our primary challenges is to help accelerate worldwide PC adoption and software upgrades, we continue to advance the functionality, security, and value of Windows operating systems, including versions for new devices such as Tablet PCs, Media Center PCs, Portable Media Centers, and mobile devices such as Smartphones. We are also increasing our focus on emerging markets and reducing the amount of unlicensed software in those markets. In addition, we develop innovative software applications and solutions to enhance the productivity of information workers, improve communication and collaboration in work groups, aid business intelligence, and streamline processes for small and mid-sized businesses. To sustain the growth of our Server and Tools business amid competition from other vendors of both proprietary and open source software, our goal is to deliver products that provide the best platform for network computing – the most advanced, easiest to deploy and manage and most secure – with the lowest total cost of ownership.

To take advantage of new market opportunities, we continue to invest in research and development of existing and new lines of business, such as services for consumers, businesses and large enterprises that we believe can contribute significantly to our long-term growth. We also research and develop advanced technologies for future software products. Delivering breakthrough innovation and high-value solutions through our integrated platform is the key to meeting customer needs and to our future growth.

We believe that over the last few years we have laid a foundation for long-term growth by delivering innovative new products, creating opportunity for partners, improving customer satisfaction with key audiences, putting some of our most significant legal cases behind us, and improving our internal business processes. Our focus in fiscal year 2006 is building on this foundation and executing well in key areas, including continuing to innovate on our integrated software platform, delivering compelling value propositions to customers, responding effectively to customer and partner needs, and continuing to focus internally on product excellence, business efficacy, and accountability across the company.

Key market opportunities include:

• Growth in our anchor businesses through forthcoming innovations and new product launches and making inroads against software piracy.
• Expanding our innovation portfolio by offering extensions of our technologies targeted towards specific customer needs – either as new products or as higher-value versions of existing products.
• Delivering software services through online consumer services and services for businesses that enable workers to collaborate interactively.

Worldwide macroeconomic factors have a strong correlation to business and consumer demand for our software, services, games and Internet service offerings. We expect that general macroeconomic trends will remain stable or experience slight improvement in fiscal year 2006 as compared to fiscal year 2005. Our optimism is balanced by recent data which revealed slight downward revisions when compared to previous forecasts for Gross Domestic Product growth in the U.S., United Kingdom, France, Germany, Japan and Latin America. The leading indicators were also revised slightly lower for the major markets. Additionally, recent surveys of chief information officers also reflect slight downward revisions in expected corporate IT spend budgets and short-term purchase intent.

As open source software development and distribution evolves, we continue to seek to differentiate our products from competitive products based on open source software. We believe that Microsoft’s share of server unit operating systems held steady in fiscal year 2005, while Linux distributions rose slightly faster on an absolute basis.

Summary

(In millions, except percentages)	2003		2004		Percent Change		2005		Percent Change
Revenue	$32,187		$36,835		14%)		$39,788		8%
Operating income	$09,545		$09,034		(5)%		$14,561		61%

Our revenue growth for fiscal year 2005 was driven by growth in licensing of Windows Server™ operating systems and other server applications, licensing of Windows^® Client operating systems through OEMs, and increased licensing of Office and other Information Worker products. The license revenue growth resulted from growth in server hardware and PC shipments, fluctuations in foreign currency exchange rates, and overall improvements in IT spending. The November 2004 launch of the “Halo 2^® ” Xbox game also contributed to the overall revenue growth for the company. Based on our preliminary estimates, worldwide PC shipments from all sources grew about 11% to 13% and total server hardware shipments grew approximately 13% to 14% during fiscal year 2005 as compared to fiscal year 2004. The net impact of foreign exchange rates on revenue was positive in 2005, primarily due to relative strengthening of most foreign currencies, particularly the euro and Japanese yen, against the U.S. dollar. Had the exchange rates from the previous year been in effect in fiscal year 2005, translated international revenue growth earned in local currencies would have been approximately $873 million or two percentage points lower for fiscal year 2005. We hedge a portion of our international currency exposures, thereby reducing our overall exposure. Fluctuations in foreign currency exchange rates have a greater impact on non-OEM commercial and retail license business as a significant portion of those product revenues are denominated in foreign currencies. The vast majority of OEM license revenue is denominated in U.S. dollars. Partially offsetting revenue growth rates was a $1.1 billion decline in earned revenue from Upgrade Advantage in fiscal year 2005. The Upgrade Advantage contract value reached its expiration dates in the first quarter of fiscal year 2005. This revenue was recognized over fiscal year 2003 and fiscal year 2004 and in the first quarter of fiscal year 2005 when the contract period expired.

Revenue growth in fiscal year 2004 was primarily driven by the growth in licensing of Windows Client operating systems through OEMs, Windows Server operating systems, Office and other server applications as a result of growth in PC and server hardware shipments. The worldwide PC shipment growth rate from all sources was estimated at 13% and the Windows server shipment was estimated at 18% in fiscal year 2004 as compared to fiscal year 2003. The net impact of foreign exchange rates on revenue was positive in fiscal year 2004 due to a relative strengthening of most foreign currencies versus the U.S. dollar. This resulted in approximately $1.10 billion growth in total revenue. Revenue growth in fiscal year 2003 was driven primarily by multi-year licensing that occurred before the Licensing 6.0 transition date in the first quarter of fiscal year 2003. The fiscal year 2003 revenue growth also reflected a $933 million or 13% increase associated with OEM licensing of Windows operating systems and a $309 million or 23% increase in revenue from Xbox video game consoles.

For fiscal year 2005, the operating income increase was driven by a decline in stock-based compensation expense; increased revenue in Server and Tools, Client and Information Worker, which have higher gross margins as compared to other segments; and a reduction in legal costs associated with major litigation. In addition, strong sales of Halo 2 reduced the overall operating loss for the Home and Entertainment segment for fiscal year 2005. The $3.29 billion decrease in stock-based compensation expense was partially offset by increased operating expenses of $562 million related to increased salary and benefits for new and existing headcount. General and administrative expenses related to major litigation declined in fiscal year 2005 due to the $2.53 billion of charges related to the settlement of Sun Microsystems litigation and the fine imposed by the European Commission in fiscal year 2004. This effect was partially offset by legal expenses of $2.08 billion related to settlements with IBM, Novell, Gateway, and end-user class action plaintiffs to resolve antitrust issues and other matters. In fiscal year 2004, the operating income decline was caused primarily by $2.53 billion of legal charges and $2.21 billion of stock-based compensation expense related to our employee stock option transfer program, mainly offset by an increase in revenue. In fiscal year 2003, the growth in operating income reflected an increase in revenue, partially offset by an increase in operating expenses related to employee and related costs associated with headcount and increased legal settlement expenses, primarily the Time Warner settlement charge of $750 million.

In fiscal year 2004, we implemented changes in employee compensation whereby employees are granted stock awards rather than stock options. We also completed an employee stock option transfer program in the second quarter of fiscal year 2004 in which employees could elect to transfer all of their vested and unvested stock options with a strike price of $33 or higher to JPMorgan. The unvested options that were transferred to JPMorgan became vested upon the transfer. A total of 345 million of the 621 million eligible options were transferred, which resulted in additional stock-based compensation expense of $2.21 billion in the second quarter of fiscal year 2004. As a result of these changes, we expect stock-based compensation expense to continue to decrease for at least the next three fiscal years.

The following table shows total stock-based compensation expense by segment and by income statement classification for fiscal years 2003, 2004 and 2005.

(In millions)	2003		2004		Increase/ (Decrease)		2005		Increase/ (Decrease)
Client	$0,454		$0,754		$0,300		$0,310		$0,(444)
Server and Tools	1,281		1,898		617		826		(1,072)
Information Worker	407		573		166		269		(304)
Microsoft Business Solutions	237		324		87		149		(175)
MSN	263		415		152		174		(241)
Mobile and Embedded Devices	130		170		40		75		(95)
Home and Entertainment	261		387		126		168		(219)
Corporate	716		1,213		497		477		(736)
Consolidated	$3,749		$5,734		$1,985		$2,448		$(3,286)
Cost of revenue	380		681		301		318		(363)
Research and development	1,964		3,117		1,153		1,241		(1,876)
Sales and marketing	1,050		1,272		222		612		(660)
General and administrative	355		664		309		277		(387)
Consolidated	$3,749		$5,734		$1,985		$2,448		$(3,286)

In fiscal year 2006, we expect revenue to grow at a higher rate than fiscal year 2005, mainly due to the launches of new products. We expect higher revenue growth in fiscal year 2006 as compared to fiscal year 2005 in Home and Entertainment primarily driven by the launch of Xbox 360. We estimate worldwide PC shipments will grow between 7% to 9% and worldwide server unit shipments will grow between 11% to 13% in fiscal year 2006 as compared to fiscal year 2005. We do not expect a benefit from year-over-year foreign currency exchange rates in fiscal year 2006.

We expect our operating income growth rate in fiscal year 2006 to exceed our revenue growth rate. Operating income is expected to reflect lower operating expenses due to lower costs for legal settlements than incurred in fiscal year 2005 and a reduction in stock-based compensation expense. The operating loss for Home and Entertainment is expected to increase in fiscal year 2006 driven by the launch of and investments in Xbox 360.

SEGMENT PRODUCT REVENUE/OPERATING INCOME (LOSS)

Our seven segments are Client; Server and Tools; Information Worker; Microsoft Business Solutions; MSN; Mobile and Embedded Devices; and Home and Entertainment.

The revenue and operating income/(loss) amounts in this section are presented on a basis consistent with U.S. Generally Accepted Accounting Principles (GAAP) and include certain reconciling items attributable to each of the segments. The segment information appearing in Note 18 – Segment Information of the Notes to Financial Statements is presented on a basis consistent with the Company’s internal management reporting, in accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information. Certain corporate level expenses have been excluded from our segment operating results and are analyzed separately. Fiscal years 2003 and 2004 amounts have been restated for certain internal reorganizations and to conform to the current period presentation including reclassifying certain legal settlements from business segments to corporate-level expense.

Client

(In millions, except percentages)	2003		2004		Percent Change		2005		Percent Change
Revenue	$10,394		$11,546		11%		$12,234		6%
Operating income	$07,960		$08,654		9%		$09,442		9%

Client includes revenue from Windows XP Professional and Home, Media Center Edition, Tablet PC Edition, and other standard Windows operating systems. Client revenue growth is correlated with the growth of corporate and consumer purchases of PCs from OEMs that pre-install versions of Windows operating systems because the OEM channel accounts for over 80% of total Client revenue. The operating results for all periods presented have been restated to reflect the reorganization of the Windows Security group from Server and Tools to Client.

Client revenue increased in fiscal year 2005 driven by 12% growth in OEM license units and $886 million or 10% growth in OEM revenue from increased PC unit shipments, partially offset by a $198 million or 9% decrease in revenue from commercial and retail licensing of Windows operating systems. This channel-mix shift reflects our customers’ continued preference for upgrading their PC operating systems through the OEM channel when they replace their PCs versus the purchase of a multi-year licensing agreement. The mix of OEM Windows operating systems licensed with premium edition operating systems as a percentage of total OEM Windows operating systems licensed during the year remained flat at 50% of total OEM Windows operating systems as compared to the previous year. Revenue earned from Upgrade Advantage declined by $99 million in fiscal year 2005 contributing to the decrease in commercial and retail licensing revenue. The differences between unit growth rates and revenue growth rates from year to year are affected by the mix of premium versions of operating systems licensed during the year, changes in the geographical mix, the channel mix of products sold by large, multi-national OEMs versus those sold by local and regional system builders, and previous changes to deferral rates and product lives for undelivered elements of unearned revenue. Client revenue increase in fiscal year 2004 was driven by 14% growth in OEM licenses and 16% growth in OEM revenue on increased consumer PC unit shipments in the first half of the fiscal year and growth in business PC unit shipments in the second half of fiscal year 2004.

Client operating income increased in fiscal year 2005 primarily due to an increase in OEM revenue and a decrease in stock-based compensation expense. These factors were partially offset by an increase in sales and marketing expenses associated with “Start Something,” a globally launched advertising campaign, marketing for security initiatives, and an increase in salary and benefits for new and existing headcount. The additional headcount for research and development was primarily devoted to the continued development of the Windows Client next-generation operating system. The operating income for fiscal year 2004 has been restated for a reclassification of legal settlement charges totaling $700 million from Client to corporate expenses to conform to the current year presentation. Client operating income increased for fiscal year 2004 compared to fiscal year 2003 mainly due to growth in revenue, partially offset by increased operating expenses primarily related to stock-based compensation expense from the employee stock option transfer program in the second quarter of fiscal year 2004.

We anticipate that worldwide PC shipments will grow at approximately 7% to 9% in fiscal year 2006, continuing to influence our growth in Client revenue. In addition, we estimate that increasing shipments of laptops as a percentage of total PC systems will continue to positively influence Client revenue growth due to shorter replacement cycles for laptops. The time between operating system releases may affect our ability to close some multi-year licensing agreements. We expect growth rates in emerging markets to continue to outpace mature market growth rates. Piracy continues to be a challenge in both emerging and mature markets. We intend to focus on growing OEM licenses faster than the overall market by reducing piracy, particularly in the mature markets, through initiatives such as Windows Genuine Advantage. Client commercial and retail licensing revenues are expected to continue to lag behind overall Client revenue growth, but we expect to see improvements in these channels in fiscal year 2006 compared to fiscal year 2005. We anticipate a modest increase in our premium product mix in fiscal year 2006, although we anticipate shipments of the premium-priced Media Center Edition will grow as a percentage of the total operating system shipments. Major investments in fiscal year 2006 will focus on development of Windows Vista, the next-generation PC operating system, and will include marketing initiatives such as the global “Start Something” campaign.

Server and Tools

(In millions, except percentages)	2003		2004		Percent Change		2005		Percent Change
Revenue	$7,192		$8,538		19%		$9,885		16%
Operating income	$1,160		$1,418		22%		$3,259		130%

Server and Tools consists of server software licenses and client access licenses (CALs) for Windows Server, Microsoft SQL Server^®, Exchange Server, and other server products. It also includes developer tools, training, certification, Microsoft Press, Premier and Professional product support services, and Microsoft Consulting Services. Server and Tools concentrates on licensing products, applications, tools, content, and services that make information technology professionals and developers more productive and efficient. The segment uses multiple channels for licensing including pre-installed OEM versions, licenses through partners, and licenses directly to end customers. The licenses are sold both as one-time licenses and as multi-year volume licenses depending upon the needs of different customers. Server and Tools uses product innovation and partnerships with information technology professionals to drive the adoption and sales growth of its products. Server and Tools growth is driven by performance of the overall market for information technology – both hardware and software. The operating results for previous years have been restated for the reorganization of the Windows Security group from Server and Tools to Client and the reorganization of Professional product support services from Information Worker to Server and Tools.

Server and Tools revenue growth in fiscal year 2005 was mainly driven by growth in Server and Server application revenue, including CAL revenue, which grew $1.1 billion or 17% in fiscal year 2005 reflecting broad adoption of Windows Server System™ products, including Windows Server, SQL Server, Exchange Server, and Management Servers. We estimate that overall server hardware shipments grew 13% to 14% during fiscal year 2005 and that Windows-based server shipments grew at a comparable rate for the same period. Consulting and Premier and Professional product support services revenue increased $241 million or 19% compared to the previous year, primarily due to increased consultant utilization and new Premier customers. Foreign currency exchange rate changes accounted for approximately $284 million or three percentage points of total Server and Tools revenue growth, which was offset by a $314 million decline in Upgrade Advantage revenue earned. In fiscal year 2004, Server and Server applications revenue, including CAL revenue, grew $1.28 billion or 25%. Foreign currency exchange rates contributed approximately $350 million or five percentage points of Server and Tools revenue growth in fiscal year 2004 compared to fiscal year 2003. Consulting and Premier product support services revenue increased $192 million or 18% compared to fiscal year 2003 due to increased customer penetration from new product offerings.

Server and Tools operating income growth for fiscal year 2005 was primarily due to an increase in revenue and a decrease in stock-based compensation expense. This was partially offset by an increase in sales and marketing costs and headcount-related costs from increased hiring and increases in salary and benefits. Operating income for the previous year has been restated for a reclassification of $1.22 billion of legal settlements from Server and Tools to corporate expenses to conform to the current year presentation. Server and Tools operating income for fiscal year 2004 increased slightly due to the revenue increase offset by increased stock-based compensation charges, including $651 million related to the employee stock option transfer program in the second quarter of fiscal year 2004.

We expect worldwide server hardware shipments to grow 11% to 13% in fiscal year 2006. However, we face strong competition from Linux-based, Unix, and other server operating systems. We anticipate little or no year-over-year foreign currency exchange rate impacts in fiscal year 2006. We also expect Server and Tools operating expenses to increase during fiscal year 2006 due to expected investment in headcount and new marketing initiatives and upcoming product releases, including SQL Server 2005 and Visual Studio 2005.

Information Worker

(In millions, except percentages)	2003		2004		Percent Change		2005		Percent Change
Revenue	$9,113		$10,653		17%		$11,013		3%
Operating income	$6,389		$07,410		16%		$07,915		7%

Information Worker consists of the Microsoft Office System of programs, servers, services, and solutions designed to increase personal, team, and organization productivity. Information Worker includes Microsoft Office, Microsoft Project, Microsoft Visio^®, SharePoint^® Portal Server CALs, and other information worker products including Microsoft LiveMeeting^® and OneNote^®. Most revenue from this segment comes from licensing our Office System products. Revenue growth depends on the ability to add value to the core Office product set and expand our product offerings in other information worker areas such as document lifecycle management, collaboration, and business intelligence.

Beginning in fiscal year 2005, the Small and Mid-Market Solutions & Partners (SMS&P) organization, which was historically part of Information Worker, was re-aligned in Microsoft Business Solutions. As a result of this change, Information Worker results have been restated to reflect the reclassification of the SMS&P organization to Microsoft Business Solutions. The results for previous periods have also been restated due to the reclassification of Professional product support services from Information Worker into Server and Tools.

Information Worker revenue increased in fiscal year 2005 primarily due to a 3% or $269 million increase in volume licensing, retail packaged product, and pre-installed versions of Office in Japan, a 6% or $91 million increase in OEM revenue, and the impact of foreign currency exchange rates, partially offset by reduced Upgrade Advantage earned revenue. Changes in foreign currency exchange rates accounted for approximately $367 million or three percentage points of the revenue growth for fiscal year 2005 as compared to the previous fiscal year, offset by a $663 million decline in Upgrade Advantage earned revenue. Revenue growth for fiscal year 2004 from volume licensing, retail packaged product and pre-installed versions of Office in Japan was 15% in aggregate. This increase was driven by recognition of unearned revenue primarily from a large increase in multi-year licenses signed previous to the transition to our Licensing 6.0 programs and approximately $110 million related to the launch of Office 2003. OEM licensing revenue grew 29% or $325 million. Foreign currency exchange rates provided approximately $485 million or 5% of total Information Worker revenue growth.

Information Worker operating income growth for fiscal year 2005 was primarily due to the revenue growth and a decrease in stock-based compensation expense. Operating expenses were also impacted by a reduction in marketing campaign costs from the previous period associated with the launch of Office 2003. This decline was offset by an increase in headcount-related costs from increased hiring and increases in salary and benefits. Information Worker operating income in fiscal year 2004 increased from the previous year primarily due to growth in revenue, partially offset by an increase in operating expenses, primarily related to $351 million of stock-based compensation expense from the employee stock option transfer program in the second quarter of fiscal year 2004 and higher sales and marketing expenses.

The revenue growth rate for Information Worker is expected to be higher in fiscal year 2006 than fiscal year 2005. We expect sustained momentum in our OEM and multi-year licensing offerings and increased purchasing of Office System 2003 as enterprises complete their product evaluations. We expect to see slowing revenue from packaged product late in the year as we approach the next version launch. We anticipate little or no year-over-year foreign currency exchange rate benefit in fiscal year 2006.

Microsoft Business Solutions

(In millions, except percentages)	2003)		2004)		Percent Change		2005)		Percent Change
Revenue	$(631)		$(759)		20%)		$(803)		6%
Operating loss	$(148)		$(315)		(113)%		$(201)		36%

Microsoft Business Solutions provides integrated and adaptable business management software solutions optimized for small and mid-sized businesses, large organizations and divisions of global enterprises. Microsoft Business Solutions products are developed to deliver affordable and rich functionality through an adaptable software platform that works like and with other Microsoft technologies. The main products consist of a line of business solutions, customer relationship management software, retail solutions, and related services. Revenue is derived from software and services sales, with software sales representing a significant amount of total revenue. Software revenues include both new software licenses and enhancement plans, which provide customers with future software upgrades over the period of the plan. Our solutions are delivered through a worldwide network of channel partners that provide specialized services and local support tailored to customer needs. The market for Microsoft Business Solutions is highly competitive, with a few strong players in the enterprise segment while the mid-market segment is more fragmented. Microsoft Business Solutions now includes the SMS&P organization, which previously had been included in Information Worker. SMS&P supports small and mid-market customers for Microsoft including Microsoft Business Solutions. Results have been restated to reflect the reclassification of SMS&P for all periods presented. Also as a result of the reorganization, the Microsoft Partner Program became a component of Microsoft Business Solutions.

The increase in Microsoft Business Solutions revenue in fiscal year 2005 was mainly due to a 10% revenue growth in software partially offset by a 25% decline in services revenue, which resulted from encouraging our partners to provide more of these types of services. The software revenue increase was driven by a 9% growth in license revenue and 16% growth in enhancement revenue as compared to the previous year, and is attributed to growth in our line of business solutions and customer relationship management solutions, and increased Microsoft Partner Program subscriptions. The revenue increase in fiscal year 2004 was primarily attributable to continued growth in licensing of Navision and Axapta line of business solutions, new sales of Microsoft CRM, and Microsoft Partner Program subscriptions.

Microsoft Business Solutions operating loss declined in fiscal year 2005 primarily due to a decline in stock-based compensation expense, an increase in product revenue, and a decline in acquisition intangibles amortization. The reduction in operating loss was partially offset by a net increase in sales and marketing expense driven by incremental headcount and marketing costs in the SMS&P organization. In addition, there has been an increase in marketing and product development investments in our portfolio of business solutions. The operating loss for fiscal year 2004 increased from fiscal year 2003 due to an increase in stock-based compensation expense from the employee stock option transfer program in the second quarter of fiscal year 2004, partially offset by an increase in revenue and lower operating expenses including $42 million of lower intangibles amortization costs.

Microsoft Business Solutions expects continued revenue growth through its portfolio of business solutions and related product releases, including newer applications such as Microsoft Office Small Business Accounting and Microsoft CRM. Continued investment in the next generation of solutions, broader geographical coverage, and plans for facilitating our partners to provide customized vertical solutions should result in improved business performance for Microsoft Business Solutions in fiscal year 2006.

MSN

(In millions, except percentages)	2003)		2004		Percent Change		2005		Percent Change
Revenue	$(1,953)		$2,216		13%		$2,274		3%
Operating income (loss)	$0,(573)		$0,087		115%		$0,405		366%

MSN includes personal communications services, such as e-mail and instant messaging, and online information offerings, such as MSN Search and the MSN portals and channels around the world. MSN also provides a variety of online paid services in addition to MSN Internet Access and MSN Premium Web Services. Revenue is derived primarily from advertisers on MSN, from consumers and partners through subscriptions and transactions generated from online paid services, and from subscribers to MSN Narrowband Internet Access. In fiscal year 2005, we launched a new version of our MSN Search engine, which is based on our own technology. This change will help provide the ability to innovate more quickly and the opportunity to develop a long-term competitive advantage in search. In addition to the launch of MSN Search, we introduced many new products and product enhancements in fiscal year 2005, including a new version of the MSN home page which provides a richer user experience, quicker load times, higher levels of end user customization, and fewer advertisements and links. MSN launched the clarity in advertising program in fiscal year 2005, which removed paid advertising from inclusion in search results and resulted in a reduced number of advertisements that are returned with search results.

In fiscal year 2005, MSN advertising revenue increased $193 million or 16% primarily as a result of industry and market growth, and continued growth of MSN display advertising revenue, tempered by the search clarity in advertising program and the impact of the home page redesign. Revenue from subscription and transaction services other than Internet Access increased $84 million or 88% in fiscal year 2005 as a result of growth in the number of MSN Premium subscribers through our carrier partnerships. Offsetting the overall revenue growth was a decline of $219 million or 24% in Internet Access revenue, driven by the continued migration of Internet Access subscribers to broadband or other competitively priced Internet service providers. At the end of the current fiscal year, MSN had 2.7 million internet access subscribers and 9.1 million total subscribers compared to 4.3 million and 8.8 million at the end of the previous year. In addition, MSN has over 420 million unique users monthly, over 205 million active Hotmail accounts, and over 175 million active Messenger accounts. In fiscal year 2004, MSN advertising revenue increased $360 million or 43% as a result of growth in paid search and growth in the overall Internet advertising market. This increase was partially offset by a decline of $168 million or 15% in Internet Access revenue. Revenue from subscription and transaction services other than Internet Access increased $71 million.

In fiscal year 2005, MSN operating income increased mainly due to a decrease in stock-based compensation expense, reduced online operations and bandwidth costs associated with the Internet Access business as the number of subscribers declines, and increased advertising and subscription revenue. The operating income increase was partially offset by an increase in headcount-related costs from increased hiring and increases in salary and benefits, and a $48 million tax benefit recorded in the first quarter of fiscal year 2004. MSN reached profitability in the first quarter of fiscal year 2004 and was profitable for fiscal year 2004. The improvement in profitability in fiscal year 2004 was primarily driven by an increase in revenue, a decline in customer acquisition costs and other expenses related to the Internet Access business, efficiency gains in the operations of the advertising and subscription businesses, and a $48 million refund of previous year taxes, partially offset by an increase in stock-based compensation expense.

MSN expects increased growth in advertising revenue as it benefits from improvements to its advertising platform and search engine and continued increases in Internet spending. We expect revenue from narrowband Internet Access to continue to decline in fiscal year 2006. Profitability may decline in fiscal year 2006 as investments are made in the development of new applications and services, the search and search monetization platform, and growth in the field sales force. MSN may from time to time continue to make investments in improving the user experience and in some cases, the number of advertisements delivered either via our search tools or via our Internet portals may be reduced to improve the overall user experience thereby helping to sustain and grow our user base. Effective July 1, 2005, functions related to MapPoint in Mobile and Embedded Devices have been moved to MSN. This reorganization will result in a corresponding change to the Mobile and Embedded Devices and MSN reported results.

Mobile and Embedded Devices

(In millions, except percentages)	2003)		2004)		Percent Change		2005)		Percent Change
Revenue	$(156)		$(247)		58%		$(337)		36%
Operating loss	$(277)		$(219)		21%		$0(46)		79%

Mobile and Embedded Devices includes Windows Mobile™ software, Windows Embedded operating systems, MapPoint ^® , and Windows Automotive. These products extend the advantages of the Windows platform to mobile devices such as PDAs, phones, and a wide range of embedded devices. The business is also responsible for managing sales and customer relationships for Microsoft overall with device manufacturers and communication sector customers. The communication sector includes network service providers (such as wireless, wireline and cable operators), and media and entertainment companies. The market for products in these segments is intensely competitive. Competitive alternatives vary based on product lines and include product offerings from commercial and non-commercial mobile operating system providers, and proprietary software developed by OEMs and mobile operators. Short product lifecycles in product lines such as Windows Mobile software may impact our continuing revenue streams.

Mobile and Embedded Devices revenue growth for fiscal year 2005 was primarily due to unit volume increases in all major product lines, especially Windows Mobile software sales and Windows Embedded operating systems. Increased revenue for Windows Mobile software was primarily driven by increased market demand for connected mobile devices such as phone-enabled PDAs and Smartphones, and strong growth in volume shipments for standalone PDAs. The increase in Windows Embedded revenue was due to our operating system being included in new product designs for both new and existing customers. Mobile and Embedded Devices also benefited from the increased demand for on-line mapping and the introduction of new MapPoint finished goods products. This new functionality resulted in increased unit sales for Mobile, Embedded, and MapPoint product categories. In fiscal year 2005, revenue for Windows Mobile software increased $46 million or 45%, revenue for Windows Embedded operating systems increased $19 million or 21% and revenue for MapPoint and Windows Automotive increased $25 million or 45%. Mobile and Embedded Devices realized positive increases in customer satisfaction ratings from both mobile operator partners and the developer community. In fiscal year 2005, Mobile and Embedded Devices released Windows Mobile 5.0 which is the latest version of our mobile operating software. Unit volume increases drove revenue growth for fiscal year 2004 over fiscal year 2003 in all major product lines. The growth was primarily due to the increased number of OEMs and mobile operators shipping Windows Mobile software for Smartphones, increases in market share for our Pocket PC and embedded products and increased usage by existing customers of our MapPoint Web Service.

Mobile and Embedded Devices operating loss for fiscal year 2005 decreased compared to fiscal year 2004 primarily due to a decrease in stock-based compensation expense. The growth in revenue and a reduction in sales and marketing expense also contributed to improved operating results in this period compared to the previous year. This improvement has been partially offset by increased salary and benefit costs from increased hiring and increased investment in research and development. The Mobile and Embedded Devices operating loss for fiscal year 2004 decreased compared to fiscal year 2003 primarily due to growth in revenue and lower marketing expenses, partially offset by $58 million of stock-based compensation expense from the employee stock option transfer program in the second quarter of fiscal year 2004.

Mobile and Embedded Devices is committed to continuing product innovation to meet the growing needs of our customers and partners. We will continue to invest in research and development and sales and marketing to develop and market evolving software solutions. In fiscal year 2006 we expect to bring added functionality to the Windows Mobile 5.0 platform through the Windows Mobile 5.0 Messaging and Security Feature Pack and the Exchange Server 2003 Service Pack 2. This solution enables business users to easily stay connected to their Microsoft Office Outlook Mobile information and helps businesses to better protect device data. We expect sales for Mobile and Embedded Devices to continue to grow in fiscal year 2006. The growth is anticipated to be driven by an overall increase in customer demand for connectivity, and an increase in the number of new devices being offered by OEMs and mobile operators incorporating Windows Mobile software and Windows Embedded operating systems. Growth is also anticipated due to a strong focus on increasing segment share in the connected device space by working with our partners to bring to market a strong portfolio of Smartphone and mobile computing devices. In addition, we are focused on bringing to market applications and services on the Windows Mobile platform that fulfill our customers desire for personalized communication devices. Effective July 1, 2005, functions related to MapPoint in Mobile and Embedded Devices have been moved to MSN. This reorganization will result in a corresponding change to the Mobile and Embedded Devices and MSN reported results.

Home and Entertainment

(In millions, except percentages)	2003)		2004)		Percent Change		2005)		Percent Change
Revenue	$(2,748)		$(2,876)		5%)		$(3,242)		13%
Operating loss	$(1,191)		$(1,220)		(2)%		$0,(391)		68%

Home and Entertainment includes the Microsoft Xbox video game console system, PC games, the Home Products Division (HPD), and TV platform products for the interactive television industry. The success of video game consoles is determined by console functionality, the portfolio of video game content for the console, and the market share of the console. Revenue and unit volumes have grown quickly since we entered the market in 2002 and we have established ourselves as one of the market leaders. We believe our competitive position and revenue is bolstered by our increasing software game attach rates, which provides higher margins to offset the declining prices on consoles sold. Xbox consoles have negative gross margins.

Home and Entertainment revenue increased in fiscal year 2005 primarily due to significant new product launches, which resulted in a $416 million or 23% increase in Xbox revenue. In the second quarter of fiscal year 2005, we introduced Halo 2, which generated over $300 million in revenue in the fiscal year. Revenue from consumer hardware and software, PC games, and TV platforms declined $50 million or 5% compared to fiscal year 2004 due to lower PC games software sales. In fiscal year 2004, Xbox revenue increased $144 million or 9% with $269 million related to higher Xbox software volumes and $117 million due to higher Xbox console volumes, partially offset by a $242 million decline related to price reductions of Xbox consoles and software. Overall, Xbox console volumes sales increased 11% in fiscal year 2004 compared to fiscal year 2003. Revenue from consumer hardware and software, PC games and TV platforms declined $16 million or 1% compared to fiscal year 2003 due to lower PC games software and PC gaming devices sales, partially offset by the new release of Mac Office.

Home and Entertainment operating loss in fiscal year 2005 decreased primarily due to an increase in high margin Xbox software sales, lower Xbox console unit costs, the lower-of-cost-or-market inventory adjustment recorded in fiscal year 2004, and a decrease in stock-based compensation expense. The decrease was partially offset by an increase in costs associated with Xbox 360 console development and launch efforts associated with it. The increase in operating loss in fiscal year 2004 was primarily due to $141 million of stock-based compensation expense from the employee stock option transfer program in the second quarter of fiscal year 2004, increased sales of negative margin consoles, and costs associated with Xbox 360 console development efforts, partially offset by increased Xbox and Mac Office software sales. The operating loss increase from fiscal year 2003 also included a lower-of-cost-or-market adjustment of approximately $90 million related to Xbox console inventory.

We expect operating expenses to continue to increase as we near the launch of Xbox 360. As a result of launch-related activities, we expect our operating loss to increase in fiscal year 2006. In fiscal year 2006, we expect Xbox console unit volumes and revenue to increase from fiscal year 2005 due to launch of the Xbox 360. In fiscal year 2006 we expect PC games revenue to increase from fiscal year 2005 driven by more new game titles.

Corporate-Level Expenses

(In millions, except percentages)	2003		2004		Percent Change		2005		Percent Change
Corporate-level expenses	$3,775		$6,781		80%		$5,822		(14)%

Certain corporate-level expenses are not allocated to our segments. Those expenses primarily include corporate operations related to broad-based sales and marketing, product support services, human resources, legal, finance, information technology, corporate development and procurement activities, certain research and development and other costs, and all litigation settlements and accrued legal contingencies.

In fiscal year 2005, corporate-level expenses decreased primarily as a result of a reduction in stock-based compensation expense and decreased corporate legal costs. Fiscal year 2005 legal costs were $2.08 billion as compared to $2.53 billion in fiscal year 2004. The legal costs in both years were primarily related to antitrust and competition law claims brought by competitors, class actions on behalf of end users, and by government regulatory bodies outside the United States.

In fiscal year 2004, corporate-level expenses increased primarily due to legal costs including a $1.92 billion charge for a settlement with the Sun Microsystems, Inc., and the fine of € 497 million ($605 million) imposed by the European Commission. In addition, stock-based compensation increased by $497 million as compared to fiscal year 2003.

Cost of Revenue

(In millions, except percentages)	2003%		2004%		Percent Change		2005%		Percent Change
Cost of revenue	$6,059%		$6,716%		11%00		$6,200%		(8)%()
As a percent of revenue	19%		18%		(1) ppt		16%		(2) ppt

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, and costs associated with the delivery of consulting services. In addition to a decrease in the cost of revenue in fiscal year 2005 due to lower stock-based compensation expense, the cost of revenue decreased due to a $140 million reduction in costs primarily associated with provisioning the MSN Internet Access business as subscriptions declined and a $169 million reduction in other product costs mainly due to Xbox consoles cost efficiency in Home and Entertainment, partially offset by increased costs in product support and consulting services costs. The increase in fiscal year 2004 was primarily due to increased product support and consulting services costs of $508 million, $214 million of stock-based compensation expense from the employee stock option transfer program, and a lower-of-cost-or-market inventory adjustment in the fourth quarter of fiscal year 2004 of approximately $90 million related to the Xbox console, partially offset by a $365 million decrease in MSN online operations costs.

Research and Development

(In millions, except percentages)	2003%		2004%		Percent Change		2005%		Percent Change
Research and development	$6,595%		$7,779%		18 %0		$6,184%		(21)%()
As a percent of revenue	21%		21%		0 ppt		16%		(5) ppt

Research and development expenses include payroll, employee benefits, stock-based compensation, and other headcount-related costs associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code and services content. Our research and development expenses decreased in fiscal year 2005 due to lower stock-based compensation expense. This expense decline was partially offset by an increase in headcount-related costs associated with incremental hiring and product development costs associated with upcoming products, primarily the Xbox 360 console and related games, SQL Server 2005, Windows Vista, and product development in Mobile and Embedded devices. The increase in fiscal year 2004 was primarily due to $1.31 billion of stock-based compensation expenses related to the option transfer program and other headcount-related payroll and other employee costs associated with a 3% increase in research and development headcount from fiscal year 2003.

Sales and Marketing

(In millions, except percentages)	2003%		2004%		Percent Change		2005%		Percent Change
Sales and marketing	$7,562%		$8,309%		10%()		$8,677%		4%()
As a percent of revenue	24%		23%		(1) ppt		22%		(1) ppt

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. For fiscal year 2005, sales and marketing expense increased slightly due to $470 million higher headcount-related costs from hiring and salary increases; higher sales and marketing costs driven by product planning, reseller marketing, and advertising campaign costs mainly related to launch of the “Start Something” campaign; launch of Halo 2; and launch arrangements for Xbox 360. The increase was offset mainly by reductions in stock-based compensation expense. Sales and marketing costs increased in fiscal year 2004 due to $400 million of stock-based compensation expense related to the option transfer program and other headcount-related costs related to a 9% increase in sales and marketing headcount.

General and Administrative

(In millions, except percentages)	2003%		2004%		Percent Change		2005%		Percent Change
General and administrative	$2,426%		$4,997%		106%()		$4,166%		(17)%()
As a percent of revenue	8%		14%		6  ppt		10%		(4) ppt

General and administrative costs include payroll, employee benefits, stock-based compensation, and other headcount-related costs associated with finance, legal, facilities, certain human resources, and other administrative headcount; and legal costs and other administrative fees. General and administrative expenses decreased in fiscal year 2005 due to lower legal costs and stock-based compensation expense, partially offset by an increase in other headcount-related costs from new and existing employees of $25 million. In fiscal year 2005, our legal expenses were driven by charges of $2.08 billion, nearly all of which were for settlements of certain antitrust claims with IBM, Novell, Gateway, and end-user class action plaintiffs, and increases in contingency reserves for anti-trust related claims. General and administrative costs increased in fiscal year 2004 primarily due to legal expenses including $1.92 billion of charges related to the Sun Microsystems settlement, a $605 million fine imposed by the European Commission, and other legal costs of approximately $104 million; $280 million of stock-based compensation expense related to the employee stock option transfer program in the second quarter of fiscal year 2004; and other headcount-related costs.

Investment Income

The components of investment income and other in each full fiscal year are as follows:

(In millions)	2003)		2004)		2005)
Dividends and interest	$1,957)		$1,892)		$1,460)
Net gains on investments	44)		1,563)		856)
Net losses on derivatives	(424)		(268)		(262)
Income/(losses) from equity investees and other	(68)		(25)		13)
Investment income and other	$1,509)		$3,162)		$2,067)

Dividends and interest income declined $432 million in fiscal year 2005 due to the combination of a greater allocation of funds to lower yielding, more liquid asset classes in preparation for the $32.64 billion special dividend paid on December 2, 2004 and a lower portfolio balance following payment of the special dividend.

Net gains on investments declined $707 million in fiscal year 2005 due primarily to greater sales of investments in the previous fiscal year in preparation for the special dividend paid on December 2, 2004. Net gains on investments also include other-than-temporary impairments of $152 million in fiscal year 2005 compared to $82 million fiscal year 2004. Investments are considered to be impaired when a decline in fair value is judged to be other than temporary. We employ a systematic methodology that considers available evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, the duration and extent to which the fair value is less than cost, and our intent and ability to hold the investment. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, operational and financing cash flow factors, and rating agency actions. Once a decline in fair value is determined to be other than temporary, an impairment charge is recorded and a new cost basis in the investment is established.

Derivative instruments are used to manage exposures to interest rates, equity prices, and foreign currency exchange rates and to facilitate portfolio diversification. Net derivative losses in fiscal year 2005 were primarily related to losses on equity derivatives, interest rate derivatives, and foreign currency contracts. During fiscal year 2005, losses related to equity derivatives used to economically hedge against a decline in equity prices were $202 million and losses related to interest rate derivatives were $53 million. These losses were offset by the combination of realized gains on sales of securities and unrealized gains related to increases in the market value of the underlying assets included as a component of other comprehensive income. Net losses related to foreign currency contracts were $53 million, related in part to hedging anticipated foreign currency revenues while the U.S. dollar generally declined against most currencies during the current fiscal year, and economically hedging foreign currency based investment exposures. Losses related to hedging foreign currency-based investment exposures were offset by unrealized gains in the underlying assets. Net gains on derivatives also included gains related to commodity positions used to provide portfolio diversification. Gains on commodity positions were $46 million during fiscal year 2005.

In fiscal year 2004, dividends and interest income decreased by $65 million mainly due to lower dividend income resulting from the exchange of AT&T 5% convertible preferred debt for common shares of Comcast during fiscal year 2003 and declining interest rates, partly offset by a larger investment portfolio. Net gains on investments include other-than-temporary impairments of $82 million in fiscal year 2004 compared to $1.15 billion in fiscal year 2003 and higher net realized gains on sales in fiscal year 2004 as we moved to more liquid investment asset classes. Net realized gains on sales were $1.65 billion in fiscal year 2004 and $1.19 billion in fiscal year 2003. The decline in impairments was due to improved market conditions. Derivative losses decreased $156 million to $268 million in fiscal year 2004 compared to fiscal year 2003 primarily due to the combined effects of interest rate movements on interest rate sensitive instruments and equity market price movements relative to positions used to hedge the fair value of certain equity securities.

Net losses on equity investees and other for the previous periods were reclassified into investment income and other to conform to the current period presentation.

Income Taxes

Our effective tax rate for the full fiscal year 2005 was 26% compared with 33% for fiscal year 2004. The decreased rate for the full year resulted primarily from the reversal of $776 million of previously accrued taxes upon settling an Internal Revenue Service examination for fiscal years 1997 to 1999 and recording a tax benefit of $179 million generated by the decision to repatriate foreign subsidiary earnings under a temporary incentive provided by the American Jobs Creation Act of 2004. The effective tax rate for fiscal year 2003 was 32%. The fiscal year 2003 rate reflected a benefit in the second quarter of $126 million which resulted from the reversal of previously accrued taxes that were related to a previous unfavorable Tax Court ruling, portions of which were reversed in 2003 by the Ninth Circuit Court of Appeals.

Financial Condition

Cash and short-term investments totaled $37.75 billion as of June 30, 2005 compared to $60.59 billion as of June 30, 2004. The decline is primarily attributable to the special dividend of $3.00 per share, or $32.64 billion, paid on December 2, 2004, and to common stock repurchases of 312 million shares for $8.0 billion during 2005. Equity and other investments were $11.00 billion as of June 30, 2005 compared to $12.21 billion as of June 30, 2004. The investment portfolio consists primarily of fixed-income securities, diversified among industries and individual issuers. Our investments are generally liquid and investment grade. The portfolio is invested predominantly in U.S. dollar denominated securities, but also includes foreign currency denominated positions in order to diversify financial risk. The portfolio is primarily invested in short-term securities to facilitate rapid deployment for immediate cash needs. As a result of the special dividend and shares repurchased, our retained deficit, including accumulated other comprehensive income, was $12.30 billion at June 30, 2005. Our retained deficit is not expected to impact our future ability to operate or pay dividends given our continuing profitability and strong cash and financial position.

Unearned Revenue

Unearned revenue is attributable to volume licensing programs, undelivered elements of software licensing arrangements, and certain other services. Unearned revenue from volume licensing programs represents customer billings, paid either upfront or at the beginning of each billing coverage period, that are accounted for as subscriptions with revenue recognized ratably over the billing coverage period. For certain other licensing arrangements revenue attributable to undelivered elements, including free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis, is based on the sales price of those elements when sold separately and is recognized ratably on a straight-line basis over the related product’s life cycle. Other unearned revenue includes Services, TV Platform, Microsoft Business Solutions, and advertising and subscription services where we have been paid upfront and earn the revenue when we provide the service or software or otherwise meet the revenue recognition criteria.

Unearned revenue as of June 30, 2005 increased $990 million from June 30, 2004 reflecting current period billings outpacing the recognition of deferrals from multi-year licensing arrangements by $925 million and a $304 million increase primarily in unearned revenue for services, MSN advertising and subscriptions, Xbox Live, TV platform, and Microsoft Business Solutions, partially offset by a $239 million decline in revenue deferred for undelivered elements.

The following table outlines the expected recognition of unearned revenue at June 30, 2005:

(In millions)	Recognition of Unearned Revenue
Three months ended:
September 30, 2005	$2,724
December 31, 2005	2,208
March 31, 2006	1,612
June 30, 2006	958
Thereafter	1,665
Unearned revenue	$9,167

Cash flow from operations for fiscal year 2005 increased 14% to $16.61 billion due primarily to an increase in cash receipts from customers driven by our 8% revenue growth combined with a 12% increase in unearned revenue. Cash payments in fiscal year 2005 resulting from significant legal settlements were approximately $1.8 billion lower than in the previous year, adding to the overall increase in operating cash flow. Partially offsetting these factors were increased payments to employees resulting from a 7% increase in full-time employees. Cash used for financing was $41.08 billion in fiscal year 2005, driven by $36.11 billion of cash dividends paid in fiscal year 2005 compared to $1.73 billion paid in fiscal year 2004. The increase was also partially driven by $8.0 billion in cash used for common stock repurchases, an increase of $4.67 billion in cash used for share repurchases compared to the previous year, reflecting 312 million shares repurchased in fiscal year 2005, an increase of 188.5 million shares compared to the previous year. Net cash from investing was $15.03 billion in fiscal year 2005, an increase of $18.37 billion from fiscal year 2004, primarily due to a $23.59 billion increase in investment maturities that occurred to fund cash dividends paid in fiscal year 2005, partially offset by a $5.32 billion decrease in cash from combined investment purchase and sale activity.

Cash flow from operations for fiscal year 2004 decreased $1.17 billion to $14.63 billion. The decrease primarily reflects the combined cash outflows of $2.56 billion related to the Sun Microsystems settlement and the European Commission fine partially offset by increased cash receipts from customers driven by the rise in revenue billings. Cash used for financing was $2.36 billion in fiscal year 2004, a decrease of $2.86 billion from the previous year. The decrease reflects that we did not repurchase common stock in the fourth quarter of fiscal year 2004 combined with a $628 million increase primarily from stock issuances related to employee stock options exercises, partially offset by an $872 million increase in cash dividends paid. We repurchased 123.7 million shares of common stock under our share repurchase program in fiscal year 2004. Cash used for investing was $3.34 billion in fiscal year 2004, a decrease of $3.88 billion from fiscal year 2003.

Cash flow from operations was $15.80 billion for fiscal year 2003, an increase of $1.29 billion from fiscal year 2002. The increase primarily reflects the rise in cash receipts from customers driven by the increase in revenue billings and maintenance of relatively stable accounts receivable levels. Cash used for financing was $5.22 billion in fiscal year 2003, an increase of $651 million from the previous year. The increase reflects a cash dividend payment of $857 million in 2003 and an increase of $417 million in common stock repurchased, offsetting $623 million received from common stock issued. We repurchased 238.2 million shares of common stock under our share repurchase program in fiscal year 2003. Cash used for investing was $7.50 billion in fiscal year 2003, a decrease of $3.37 billion from fiscal year 2002, due to stronger portfolio performance on sold and matured investments.

We have no material long-term debt. Stockholders’ equity at June 30, 2005 was $48.12 billion. We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology. Additions to property and equipment will continue, including new facilities and computer systems for research and development, sales and marketing, support, and administrative staff. Commitments for constructing new buildings were $152 million on June 30, 2005. We have operating leases for most U.S. and international sales and support offices and certain equipment under which we incurred rental expense totaling, $290 million, $331 million and $299 million in fiscal year 2003, 2004 and 2005, respectively. We have issued residual value guarantees in connection with various operating leases. These guarantees provide that if we do not purchase the leased property from the lessor at the end of the lease term, then we are liable to the lessor for an amount equal to the shortage (if any) between the proceeds from the sale of the property and an agreed value. As of June 30, 2005, the maximum amount of the residual value guarantees was approximately $271 million. We believe that proceeds from the sale of properties under operating leases would exceed the payment obligation and therefore no liability currently exists. We have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of requirements for capital resources.

In fiscal year 2005, our Board of Directors approved $3.40 per share cash dividends, with $3.32 paid as of June 30, 2005. A quarterly dividend of $0.08 per share (or approximately $857 million) was approved by our Board of Directors on June 15, 2005 to be paid to shareholders of record as of August 17, 2005 on September 8, 2005.

On July 20, 2004, our Board of Directors approved a plan to buy back up to $30 billion in Microsoft common stock over four years. The specific timing and amount of repurchases will vary based on market conditions, securities law limitations, and other factors. The repurchases will be made using our cash resources. The repurchase program may be suspended or discontinued at any time without previous notice. In any period, cash used in financing activities related to common stock repurchased may differ from the comparable change in stockholders’ equity, reflecting timing differences between the recognition of share repurchase transactions and their settlement for cash. During fiscal year 2005, we repurchased 312 million shares, or $8.0 billion of our common stock under this plan.

We believe existing cash and short-term investments, together with funds generated from operations should be sufficient to meet operating requirements, quarterly dividends and planned share repurchases. Our philosophy regarding the maintenance of a balance sheet with a large component of cash and short-term investments, and equity and other investments, reflects our views on potential future capital requirements relating to research and development, creation and expansion of sales distribution channels, investments and acquisitions, share dilution management, legal risks, and challenges to our business model. We regularly assess our investment management approach in view of our current and potential future needs.

Off-Balance Sheet Arrangements and Contractual Obligations

Off-Balance Sheet Arrangements

As of June 30, 2004, we had guaranteed the repayment of certain Japanese yen denominated bank loans and related interest and fees of Jupiter Telecommunication, Ltd., a Japanese cable company. The total amount of these guarantees was approximately $51 million. Effective December 21, 2004, the guarantees were terminated.

We provide indemnifications of varying scope and amount to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products. We evaluate estimated losses for such indemnifications under SFAS No. 5, Accounting for Contingencies, as interpreted by FASB Interpretation No. (FIN) 45. We consider factors such as the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, we have not encountered material costs as a result of such obligations and have not accrued any liabilities related to such indemnifications in our financial statements.

Contractual Obligations

The following table summarizes our outstanding contractual obligations as of June 30, 2005:

(In millions) (1)
	Payments due by period
Fiscal Years	2006		2007-2009		2010-2012		2013 and thereafter		Total
Long-term debt	$0,00–		$00–		$00–		$00–		$0,00–
Construction commitments (2)	122		28		2		–		152
Lease obligations:
Capital leases	6		17		11		–		34
Operating leases (3)	230		493		214		96		1,033
Purchase commitments (4)	1,072		1		–		–		1,073
Other long-term liabilities (5)	–		95		17		12		124
Total contractual obligations	$1,430		$634		$244		$108		$2,416

RECENTLY ISSUED ACCOUNTING STANDARDS

In November 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 151, Inventory Costs, which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material. SFAS No. 151 will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We do not believe the adoption of SFAS No. 151 will have a material impact on our financial statements.

In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, which eliminates the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. SFAS No. 153 will be effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. We do not believe the adoption of SFAS No. 153 will have a material impact on our financial statements.

In December 2004, the FASB issued SFAS No. 123(R), Share-Based Payment, which establishes standards for transactions in which an entity exchanges its equity instruments for goods or services. This standard requires an issuer to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. This eliminates the exception to account for such awards using the intrinsic method previously allowable under Accounting Principles Board (APB) Opinion No. 25. In March 2005, the SEC released Staff Accounting Bulletin (SAB) 107, Share-Based Payment, which expresses views of the SEC Staff about the application of SFAS No. 123(R). In April 2005 the SEC issued a rule that SFAS No. 123(R) will be effective for annual reporting periods beginning on or after June 15, 2005. We previously adopted the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, on July 1, 2003 and restated previous periods at that time for all awards granted to employees after July 1, 1995. Accordingly we believe SFAS No. 123(R) will not have a material impact on our financial statements; however, we continue to assess the potential impact that the adoption of SFAS No. 123(R) will have on the classification of tax deductions for stock-based compensation in our statements of cash flows.

APPLICATION OF CRITICAL ACCOUNTING POLICIES

Our financial statements and accompanying notes are prepared in accordance with U.S. GAAP. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Critical accounting policies for us include revenue recognition, impairment of investment securities, impairment of goodwill, accounting for research and development costs, accounting for legal contingencies, accounting for income taxes, and accounting for stock-based compensation.

We account for the licensing of software in accordance with American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 97-2, Software Revenue Recognition. The application of SOP 97-2 requires judgment, including whether a software arrangement includes multiple elements, and if so, whether vendor-specific objective evidence (VSOE) of fair value exists for those elements. Customers receive certain elements of our products over a period of time. These elements include free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis, the fair value of which is recognized over the product’s estimated life cycle. Changes to the elements in a software arrangement, the ability to identify VSOE for those elements, the fair value of the respective elements, and changes to a product’s estimated life cycle could materially impact the amount of earned and unearned revenue. Judgment is also required to assess whether future releases of certain software represent new products or upgrades and enhancements to existing products.

SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and SEC SAB 59, Accounting for Noncurrent Marketable Equity Securities, provide guidance on determining when an investment is other-than-temporarily impaired. Investments are reviewed quarterly for indicators of other-than-temporary impairment. This determination requires significant judgment. In making this judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, the duration and extent to which the fair value is less than cost, and our intent and ability to hold the investment. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, operational and financing cash flow factors, and rating agency actions. Once a decline in fair value is determined 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, 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 account for research and development costs in accordance with several 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 shortly before the products are released to manufacturing. Costs incurred after technological feasibility is established are not material, and accordingly, we expense all research and development costs when 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 financial position or our results of operations.

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.

We account for stock-based compensation in accordance with the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation. Under the fair value recognition provisions of SFAS No. 123, stock-based compensation cost is measured at the grant date based on the value of the award and is recognized as expense over the vesting period. Determining the fair value of stock-based awards at the grant date requires judgment, including estimating the expected term of stock options, the expected volatility of our stock and expected dividends. In addition, judgment is also required in estimating the amount of stock-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