Item 2. Nine Months Ended March 31, 2022 Compared with Nine Months Ended March 31, 2021

Nine Months Ended March 31, 202****2 Compared with Nine Months Ended March 31, 202****1

Revenue increased $24.5 billion or 20% driven by growth across each of our segments. Intelligent Cloud revenue increased driven by Azure and other cloud services. Productivity and Business Processes revenue increased driven by Office 365 Commercial and LinkedIn. More Personal Computing revenue increased driven by Windows, Search and news advertising, and Gaming.

Cost of revenue increased $8.0 billion or 21% driven by growth in Microsoft Cloud.

Gross margin increased $16.5 billion or 20% driven by growth across each of our segments.

	•	Gross margin percentage decreased slightly. Excluding the impact of the change in accounting estimate, gross margin percentage increased 2 points driven by improvements across each of our segments.

	•	Microsoft Cloud gross margin percentage decreased slightly to 70%. Excluding the impact of the change in accounting estimate, Microsoft Cloud gross margin percentage increased 3 points driven by improvement across our cloud services, offset in part by sales mix shift to Azure and other cloud services.

Operating expenses increased $4.5 billion or 14% driven by investments in cloud engineering, LinkedIn, Gaming, and commercial sales.

Key changes in operating expenses were:

	•	Research and development expenses increased $2.6 billion or 18% driven by investments in cloud engineering and Gaming.

	•	Sales and marketing expenses increased $1.3 billion or 9% driven by investments in commercial sales, LinkedIn, and Windows marketing.

	•	General and administrative expenses increased $566 million or 16% driven by investments in corporate functions.

Operating income increased $12.0 billion or 24% driven by growth across each of our segments.

Current year net income and diluted EPS were positively impacted by the net tax benefit related to the transfer of intangible properties, which resulted in an increase to net income and diluted EPS of $3.3 billion and $0.43, respectively. Prior year net income and diluted EPS were positively impacted by the net tax benefit related to the India Supreme Court decision on withholding taxes, which resulted in an increase to net income and diluted EPS of $620 million and $0.08, respectively.

SEGMENT RESULTS OF OPERATIONS

(In millions, except percentages)		Three Months Ended March 31,								Percentage Change				Nine Months Ended March 31,								Percentage Change
		2022				2021									2022				2021
Revenue
Productivity and Business Processes		$	15,789			$	13,552				17%			$	46,764			$	39,224				19%
Intelligent Cloud			19,051				15,118				26%				54,342				42,705				27%
More Personal Computing			14,520				13,036				11%				45,299				40,007				13%
Total		$	49,360			$	41,706				18%			$	146,405			$	121,936				20%
Operating Income
Productivity and Business Processes		$	7,184			$	6,029				19%			$	22,453			$	17,916				25%
Intelligent Cloud			8,281				6,425				29%				24,040				18,339				31%
More Personal Computing			4,899				4,594				7%				16,356				14,566				12%
Total		$	20,364			$	17,048				19%			$	62,849			$	50,821				24%

PART I

Item 2

Reportable Segments

Three Months Ended March 31, 2022 Compared with Three Months Ended March 31, 2021

Productivity and Business Processes

Revenue increased $2.2 billion or 17%.

	•	Office Commercial products and cloud services revenue increased $999 million or 12%. Office 365 Commercial revenue grew 17% driven by seat growth of 16%, with continued momentum in small and medium business and frontline worker offerings, as well as growth in revenue per user. Office Commercial products revenue declined 28% driven by continued customer shift to cloud offerings.

	•	Office Consumer products and cloud services revenue increased $150 million or 11% driven by Microsoft 365 Consumer subscription revenue. Microsoft 365 Consumer subscribers grew 16% to 58.4 million.

	•	LinkedIn revenue increased $875 million or 34% driven by a strong job market in our Talent Solutions business and advertising demand in our Marketing Solutions business.

	•	Dynamics products and cloud services revenue increased 22% driven by Dynamics 365 growth of 35%.

Operating income increased $1.2 billion or 19%.

	•	Gross margin increased $1.7 billion or 16% driven by growth in Office 365 Commercial and LinkedIn. Gross margin percentage was relatively unchanged. Excluding the impact of the change in accounting estimate, gross margin percentage increased 2 points driven by improvement across all cloud services.

	•	Operating expenses increased $565 million or 13% driven by investments in LinkedIn and cloud engineering.

Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 2%, 3%, and 4%, respectively.

Intelligent Cloud

Revenue increased $3.9 billion or 26%.

	•	Server products and cloud services revenue increased $3.8 billion or 29% driven by Azure and other cloud services. Azure and other cloud services revenue grew 46% driven by growth in our consumption-based services. Server products revenue increased 5% driven by hybrid solutions, including Windows Server and SQL Server running in multi-cloud environments.

	•	Enterprise Services revenue increased $88 million or 5% driven by growth in Enterprise Support Services.

Operating income increased $1.9 billion or 29%.

	•	Gross margin increased $2.6 billion or 24% driven by growth in Azure and other cloud services. Gross margin percentage decreased. Excluding the impact of the change in accounting estimate, gross margin percentage increased 1 point driven by improvement in Azure and other cloud services, offset in part by sales mix shift to Azure and other cloud services.

	•	Operating expenses increased $753 million or 17% driven by investments in Azure and other cloud services.

Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 3%, 3%, and 4%, respectively. Operating expenses included a favorable foreign currency impact of 2%.

More Personal Computing

Revenue increased $1.5 billion or 11%.

	•	Windows revenue increased $614 million or 11% driven by growth in Windows OEM and Windows Commercial. Windows OEM revenue increased 11% driven by continued strength in the commercial PC market, which has higher revenue per license. Windows Commercial products and cloud services revenue increased 14% driven by demand for Microsoft 365.

	•	Search and news advertising revenue increased $544 million or 23%. Search and news advertising revenue excluding traffic acquisition costs increased 23% driven by higher revenue per search and search volume.

PART I

Item 2

| | • | Gaming revenue increased $207 million or 6% on a strong prior year comparable that benefited from Xbox Series X|S launches, driven by growth in Xbox content and services and Xbox Hardware. Xbox content and services revenue increased 4% driven by growth in Xbox Game Pass subscriptions and first-party titles, offset in part by a decline in third-party titles. Xbox hardware revenue increased 14% due to continued demand for Xbox Series X|S. | | --- | --- | --- | --- | --- |

	•	Surface revenue increased $195 million or 13%.

Operating income increased $305 million or 7%.

	•	Gross margin increased $755 million or 10% driven by growth in Windows and Search and news advertising. Gross margin percentage decreased slightly.

	•	Operating expenses increased $450 million or 17% driven by investments in Gaming, Search and news advertising, and Windows marketing.

Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 2%, 3%, and 3%, respectively.

Nine Months Ended March 31, 2022 Compared with Nine Months Ended March 31, 2021

Productivity and Business Processes

Revenue increased $7.5 billion or 19%.

	•	Office Commercial products and cloud services revenue increased $3.5 billion or 14%. Office 365 Commercial revenue grew 20% driven by seat growth of 16%, with continued momentum in small and medium business and frontline worker offerings, as well as growth in revenue per user. Office Commercial products revenue declined 19% driven by continued customer shift to cloud offerings, on a low prior year comparable impacted by a slowdown in transactional licensing.

	•	Office Consumer products and cloud services revenue increased $505 million or 12% driven by Microsoft 365 Consumer subscription revenue.

	•	LinkedIn revenue increased $2.8 billion or 38% driven by a strong job market in our Talent Solutions business and advertising demand in our Marketing Solutions business.

	•	Dynamics products and cloud services revenue increased 27% driven by Dynamics 365 growth of 42%.

Operating income increased $4.5 billion or 25%.

	•	Gross margin increased $5.9 billion or 19% driven by growth in Office 365 Commercial and LinkedIn. Gross margin percentage was relatively unchanged. Excluding the impact of the change in accounting estimate, gross margin percentage increased 2 points driven by improvement across all cloud services.

	•	Operating expenses increased $1.4 billion or 11% driven by investments in cloud engineering and LinkedIn.

Intelligent Cloud

Revenue increased $11.6 billion or 27%.

	•	Server products and cloud services revenue increased $11.4 billion or 31% driven by Azure and other cloud services. Azure and other cloud services revenue grew 47% driven by growth in our consumption-based services. Server products revenue increased 8% driven by hybrid solutions, including Windows Server and SQL Server running in multi-cloud environments.

	•	Enterprise Services revenue increased $370 million or 7% driven by growth in Enterprise Support Services and Microsoft Consulting Services.

Operating income increased $5.7 billion or 31%.

	•	Gross margin increased $7.5 billion or 24% driven by growth in Azure and other cloud services. Gross margin percentage decreased. Excluding the impact of the change in accounting estimate, gross margin percentage increased 1 point driven by improvement in Azure and other cloud services, offset in part by sales mix shift to Azure and other cloud services.

	•	Operating expenses increased $1.8 billion or 15% driven by investments in Azure and other cloud services.

PART I

Item 2

More Personal Computing

Revenue increased $5.3 billion or 13%.

	•	Windows revenue increased $2.2 billion or 14% driven by growth in Windows OEM and Windows Commercial. Windows OEM revenue increased 16% driven by continued strength in the commercial PC market, which has higher revenue per license. Windows Commercial products and cloud services revenue increased 13% driven by demand for Microsoft 365.

	•	Search and news advertising revenue increased $1.9 billion or 29%. Search and news advertising revenue excluding traffic acquisition costs increased 31% driven by higher revenue per search.

| | • | Gaming revenue increased $1.1 billion or 10% on a strong prior year comparable that benefited from Xbox Series X|S launches and stay-at-home scenarios, driven by growth in Xbox hardware and Xbox content and services. Xbox hardware revenue increased 25% due to continued demand for Xbox Series X|S. Xbox content and services revenue increased 6% driven by growth in first-party titles and Xbox Game Pass subscriptions, offset in part by a decline in third-party titles. | | --- | --- | --- | --- | --- |

	•	Surface revenue increased $90 million or 2%.

Operating income increased $1.8 billion or 12%.

	•	Gross margin increased $3.0 billion or 14% driven by growth in Windows and Search and news advertising. Gross margin percentage increased slightly driven by sales mix shift to higher margin businesses and improvement in Search and news advertising.

	•	Operating expenses increased $1.3 billion or 16% driven by investments in Gaming, Windows marketing, and Search and news advertising.

OPERATING EXPENSES

Research and Development

(In millions, except percentages)		Three Months Ended March 31,								Percentage Change				Nine Months Ended March 31,								Percentage Change
		2022				2021									2022				2021
Research and development		$	6,306			$	5,204				21%			$	17,663			$	15,029				18%
As a percent of revenue			13%				12%				1ppt				12%				12%				0ppt

Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses 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.

Three Months Ended March 31, 2022 Compared with Three Months Ended March 31, 2021

Research and development expenses increased $1.1 billion or 21% driven by investments in cloud engineering.

Nine Months Ended March 31, 2022 Compared with Nine Months Ended March 31, 2021

Research and development expenses increased $2.6 billion or 18% driven by investments in cloud engineering and Gaming.

PART I

Item 2

Sales and Marketing

(In millions, except percentages)		Three Months Ended March 31,								Percentage Change				Nine Months Ended March 31,								Percentage Change
		2022				2021									2022				2021
Sales and marketing		$	5,595			$	5,082				10%			$	15,521			$	14,260				9%
As a percent of revenue			11%				12%				(1)ppt				11%				12%				(1)ppt

Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, trade shows, seminars, and other programs.

Three Months Ended March 31, 2022 Compared with Three Months Ended March 31, 2021

Sales and marketing expenses increased $513 million or 10% driven by investments in commercial sales and LinkedIn. Sales and marketing included a favorable foreign currency impact of 3%.

Nine Months Ended March 31, 2022 Compared with Nine Months Ended March 31, 2021

Sales and marketing expenses increased $1.3 billion or 9% driven by investments in commercial sales, LinkedIn, and Windows marketing.

General and Administrative

(In millions, except percentages)		Three Months Ended March 31,								Percentage Change				Nine Months Ended March 31,								Percentage Change
		2022				2021									2022				2021
General and administrative		$	1,480			$	1,327				12%			$	4,151			$	3,585				16%
As a percent of revenue			3%				3%				0ppt				3%				3%				0ppt

General and administrative expenses include payroll, employee benefits, stock-based compensation expense, severance expense, and other headcount-related expenses associated with finance, legal, facilities, certain human resources and other administrative personnel, certain taxes, and legal and other administrative fees.

Three Months Ended March 31, 2022 Compared with Three Months Ended March 31, 2021

General and administrative expenses increased $153 million or 12% driven by investments in corporate functions. General and administrative included a favorable foreign currency impact of 2%.

Nine Months Ended March 31, 2022 Compared with Nine Months Ended March 31, 2021

General and administrative expenses increased $566 million or 16% driven by investments in corporate functions.

PART I

Item 2

OTHER INCOME (EXPENSE), NET

The components of other income (expense), net were as follows:

(In millions)		Three Months Ended March 31,									Nine Months Ended March 31,
		2022				2021					2022				2021
Interest and dividends income		$	519			$	519			$	1,542			$	1,634
Interest expense			(503	)			(633	)			(1,567	)			(1,793	)
Net recognized gains (losses) on investments			(76	)			353				595				837
Net losses on derivatives			(29	)			(2	)			(29	)			(4	)
Net gains (losses) on foreign currency remeasurements			(74	)			(55	)			(152	)			126
Other, net			(11	)			6				(9	)			76
Total		$	(174	)		$	188			$	380			$	876

We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; enhance investment returns; and facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are not designated as hedging instruments are primarily recognized in other income (expense), net.

Three Months Ended March 31, 2022 Compared with Three Months Ended March 31, 2021

Interest and dividends income was unchanged as lower portfolio balances were offset by higher yields on interest rate securities. Interest expense decreased due to a decrease in outstanding long-term debt due to debt maturities. Net recognized losses on investments increased due to losses on equity securities in the current period compared to gains in the prior period.

Nine Months Ended March 31, 2022 Compared with Nine Months Ended March 31, 2021

Interest and dividends income decreased due to lower portfolio balances. Interest expense decreased due to a decrease in outstanding long-term debt due to debt maturities. Net recognized gains on investments decreased due to lower gains on equity securities.

INCOME TAXES

Effective Tax Rate

Our effective tax rate was 17% and 10% for the three months ended March 31, 2022 and 2021, respectively, and 11% and 13% for the nine months ended March 31, 2022 and 2021, respectively. The increase in our effective tax rate for the three months ended March 31, 2022 compared to the prior year was primarily due to tax benefits from a decision by the India Supreme Court on withholding taxes in the case of Engineering Analysis Centre of Excellence Private Limited vs The Commissioner of Income Tax and an agreement between the U.S. and India tax authorities related to transfer pricing in fiscal year 2021, a decrease in tax benefits relating to stock-based compensation, and changes in the mix of our income before income taxes between the U.S. and foreign countries. The decrease in our effective tax rate for the nine months ended March 31, 2022 compared to the prior year was primarily due to a $3.3 billion net income tax benefit in the first quarter of fiscal year 2022 related to the transfer of intangible properties, offset in part by tax benefits from the India Supreme Court decision on withholding taxes and an agreement between the U.S. and India tax authorities related to transfer pricing in fiscal year 2021, and changes in the mix of our income before income taxes between the U.S. and foreign countries.

We have historically paid India withholding taxes on software sales through distributor withholding and tax audit assessments in India. In March 2021, the India Supreme Court ruled favorably for companies in 86 separate appeals, some dating back to 2012, holding that software sales are not subject to India withholding taxes. Although we were not a party to the appeals, our software sales in India were determined to be not subject to withholding taxes. Therefore, we recorded a net income tax benefit of $620 million in the third quarter of fiscal year 2021 to reflect the results of the India Supreme Court decision impacting fiscal year 1996 through fiscal year 2016.

PART I

Item 2

In the first quarter of fiscal year 2022, we transferred certain intangible properties from our Puerto Rico subsidiary to the U.S. The transfer of intangible properties resulted in a $3.3 billion net income tax benefit in the first quarter of fiscal year 2022, as the value of future U.S. tax deductions exceeds the current tax liability from the U.S. global intangible low-taxed income tax.

Our effective tax rate was lower than the U.S. federal statutory rate for the three and nine months ended March 31, 2022, primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations center in Ireland, tax benefits relating to stock-based compensation, and for the nine months ended March 31, 2022, the net income tax benefit related to the transfer of intangible properties.

Uncertain Tax Positions

We settled a portion of the Internal Revenue Service (“IRS”) audit for tax years 2004 to 2006 in fiscal year 2011. In February 2012, the IRS withdrew its 2011 Revenue Agents Report related to unresolved issues for tax years 2004 to 2006 and reopened the audit phase of the examination. We also settled a portion of the IRS audit for tax years 2007 to 2009 in fiscal year 2016, and a portion of the IRS audit for tax years 2010 to 2013 in fiscal year 2018. In the second quarter of fiscal year 2021, we settled an additional portion of the IRS audits for tax years 2004 to 2013 and made a payment of $1.7 billion, including tax and interest. We remain under audit for tax years 2004 to 2017.

As of March 31, 2022, the primary unresolved issues for the IRS audits relate to transfer pricing, which could have a material impact in our consolidated financial statements when the matters are resolved. We believe our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved key transfer pricing issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months.

We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2021, some of which are currently under audit by local tax authorities. The resolution of each of these audits is not expected to be material to our consolidated financial statements.

NON-GAAP FINANCIAL MEASURES

Adjusted net income and adjusted diluted EPS are non-GAAP financial measures which exclude the net tax benefit related to the transfer of intangible properties in the first quarter of fiscal year 2022 and the net income tax benefit related to an India Supreme Court decision on withholding taxes in the third quarter of fiscal year 2021. We believe these non-GAAP measures aid investors by providing additional insight into our operational performance and help clarify trends affecting our business. For comparability of reporting, management considers non-GAAP measures in conjunction with GAAP financial results in evaluating business performance. These non-GAAP financial measures presented should not be considered a substitute for, or superior to, the measures of financial performance prepared in accordance with GAAP.

PART I

Item 2

The following table reconciles our financial results reported in accordance with GAAP to non-GAAP financial results:

(In millions, except percentages and per share amounts)			Three Months Ended March 31,								Percentage Change				Nine Months Ended March 31,								Percentage Change
			2022				2021								2022				2021
Net income		$	16,728			$	15,457				8%			$	55,998			$	44,813				25%
Net income tax benefit related to transfer of intangible properties			0				0				*				(3,291	)			0				*
Net income tax benefit related to India Supreme Court decision on withholding taxes			0				(620	)			*				0				(620	)			*
Adjusted net income (non-GAAP)		$	16,728			$	14,837				13%			$	52,707			$	44,193				19%
Diluted earnings per share		$	2.22			$	2.03				9%			$	7.41			$	5.88				26%
Net income tax benefit related to transfer of intangible properties			0				0				*				(0.43	)			0				*
Net income tax benefit related to India Supreme Court decision on withholding taxes			0				(0.08	)			*				0				(0.08	)			*
Adjusted diluted earnings per share (non-GAAP)		$	2.22			$	1.95				14%			$	6.98			$	5.80				20%

*	Not meaningful.

FINANCIAL CONDITION

Cash, Cash Equivalents, and Investments

Cash, cash equivalents, and short-term investments totaled $104.7 billion and $130.3 billion as of March 31, 2022 and June 30, 2021, respectively. Equity investments were $6.9 billion and $6.0 billion as of March 31, 2022 and June 30, 2021, respectively. Our short-term investments are primarily intended to facilitate liquidity and capital preservation. They consist predominantly of highly liquid investment-grade fixed-income securities, diversified among industries and individual issuers. The investments are predominantly U.S. dollar-denominated securities, but also include foreign currency-denominated securities to diversify risk. Our fixed-income investments are exposed to interest rate risk and credit risk. The credit risk and average maturity of our fixed-income portfolio are managed to achieve economic returns that correlate to certain fixed-income indices. The settlement risk related to these investments is insignificant given that the short-term investments held are primarily highly liquid investment-grade fixed-income securities.

Valuation

In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine the fair value of our financial instruments. This pricing methodology applies to our Level 1 investments, such as U.S. government securities, common and preferred stock, and mutual funds. 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. This pricing methodology applies to our Level 2 investments, such as commercial paper, certificates of deposit, U.S. agency securities, foreign government bonds, mortgage- and asset-backed securities, corporate notes and bonds, and municipal securities. Level 3 investments are valued using internally-developed models with unobservable inputs. Assets and liabilities measured at fair value on a recurring basis using unobservable inputs are an immaterial portion of our portfolio.

PART I

Item 2

A majority of our investments are priced by pricing vendors and are generally Level 1 or Level 2 investments as these vendors either provide a quoted market price in an active market or use observable inputs for their pricing without applying significant adjustments. Broker pricing is used mainly when a quoted price is not available, the investment is not priced by our pricing vendors, or when a broker price is more reflective of fair values in the market in which the investment trades. Our broker-priced investments are generally classified as Level 2 investments because the broker prices these investments based on similar assets without applying significant adjustments. In addition, all our broker-priced investments have a sufficient level of trading volume to demonstrate that the fair values used are appropriate for these investments. Our fair value processes include controls that are designed to ensure appropriate fair values are recorded. These controls include model validation, review of key model inputs, analysis of period-over-period fluctuations, and independent recalculation of prices where appropriate.

Cash Flows

Cash from operations increased $10.4 billion to $64.4 billion for the nine months ended March 31, 2022, mainly due to an increase in cash received from customers, offset in part by an increase in cash paid to suppliers and employees. Cash used in financing increased $8.5 billion to $45.6 billion for the nine months ended March 31, 2022, mainly due to a $5.3 billion increase in repayments of debt and a $3.7 billion increase in common stock repurchases. Cash used in investing increased $3.9 billion to $20.6 billion for the nine months ended March 31, 2022, mainly due to a $12.4 billion increase in cash used for acquisitions of companies, net of cash acquired, and purchases of intangible and other assets, and a $2.8 billion increase in additions to property and equipment, offset in part by a $11.7 billion increase in cash from net investment purchases, sales, and maturities.

Debt

We issue debt to take advantage of favorable pricing and liquidity in the debt markets, reflecting our credit rating and the low interest rate environment. The proceeds of these issuances were or will be used for general corporate purposes, which may include, among other things, funding for working capital, capital expenditures, repurchases of capital stock, acquisitions, and repayment of existing debt. In March 2021 and June 2020, we exchanged a portion of our existing debt at a premium for cash and new debt with longer maturities to take advantage of favorable financing rates in the debt markets, reflecting our credit rating and the low interest rate environment. Refer to Note 10 – Debt of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion.

Unearned Revenue

Unearned revenue comprises mainly unearned revenue related to volume licensing programs, which may include Software Assurance (“SA”) and cloud services. Unearned revenue is generally invoiced annually at the beginning of each contract period for multi-year agreements and recognized ratably over the coverage period. Unearned revenue also includes payments for other offerings for which we have been paid in advance and earn the revenue when we transfer control of the product or service.

The following table outlines the expected future recognition of unearned revenue as of March 31, 2022:

(In millions)
Three Months Ending
June 30, 2022		$	16,179
September 30, 2022			8,873
December 31, 2022			6,481
March 31, 2023			2,494
Thereafter			2,769
Total		$	36,796

If our customers choose to license cloud-based versions of our products and services rather than licensing transaction-based products and services, the associated revenue will shift from being recognized at the time of the transaction to being recognized over the subscription period or upon consumption, as applicable.

PART I

Item 2

Share Repurchases

For the nine months ended March 31, 2022 and 2021, we repurchased 67 million shares and 77 million shares of our common stock for $20.2 billion and $16.8 billion, respectively, through our share repurchase programs. All repurchases were made using cash resources. Refer to Note 15 – Stockholders’ Equity of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion.

Dividends

Refer to Note 15 – Stockholders’ Equity of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion.

Off-Balance Sheet Arrangements

We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. Additionally, we have agreed to cover damages resulting from breaches of certain security and privacy commitments in our cloud business. In evaluating estimated losses on these obligations, we consider factors such as the degree of probability of an unfavorable outcome and our ability to make a reasonable estimate of the amount of loss. These obligations did not have a material impact in our consolidated financial statements during the periods presented.

Other Planned Uses of Capital

On January 18, 2022, we entered into a definitive agreement to acquire Activision Blizzard, Inc. (“Activision Blizzard”) for $95.00 per share in an all-cash transaction valued at $68.7 billion, inclusive of Activision Blizzard’s net cash. We expect this acquisition to close in fiscal year 2023, subject to approval by Activision Blizzard’s shareholders, the satisfaction of certain regulatory approvals, and other customary closing conditions.

We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology, as well as continue making acquisitions that align with our business strategy. Additions to property and equipment will continue, including new facilities, datacenters, and computer systems for research and development, sales and marketing, support, and administrative staff. We expect capital expenditures to increase in coming years to support growth in our cloud offerings. We have operating and finance leases for datacenters, corporate offices, research and development facilities, Microsoft Experience Centers, and certain equipment. 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 capital resources.

Liquidity

As a result of the TCJA, we are required to pay a one-time transition tax on deferred foreign income not previously subject to U.S. income tax. Under the TCJA, the transition tax is payable in interest-free installments over eight years, with 8% due in each of the first five years, 15% in year six, 20% in year seven, and 25% in year eight. We have paid transition tax of $6.2 billion, which included $1.5 billion during the nine months ended March 31, 2022. The remaining transition tax of $12.0 billion is payable over the next four years with a final payment in fiscal year 2026.

We expect existing cash, cash equivalents, short-term investments, cash flows from operations, and access to capital markets to continue to be sufficient to fund our operating activities and cash commitments for investing and financing activities, such as dividends, share repurchases, debt maturities, material capital expenditures, and the transition tax related to the TCJA, for at least the next 12 months and thereafter for the foreseeable future.

RECENT ACCOUNTING GUIDANCE

Refer to Note 1 – Accounting Policies of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion.

PART I

Item 2

APPLICATION OF CRITICAL ACCOUNTING POLICIES

Our consolidated financial statements and accompanying notes are prepared in accordance with GAAP. Preparing consolidated 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, as well as uncertainty in the current economic environment due to COVID-19. Critical accounting policies for us include revenue recognition, impairment of investment securities, goodwill, research and development costs, legal and other contingencies, income taxes, and inventories.

Revenue Recognition

Our contracts with customers often include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment. When a cloud-based service includes both on-premises software licenses and cloud services, judgment is required to determine whether the software license is considered distinct and accounted for separately, or not distinct and accounted for together with the cloud service and recognized over time. Certain cloud services, primarily Office 365, depend on a significant level of integration, interdependency, and interrelation between the desktop applications and cloud services, and are accounted for together as one performance obligation. Revenue from Office 365 is recognized ratably over the period in which the cloud services are provided.

Judgment is required to determine the stand-alone selling price (“SSP") for each distinct performance obligation. We use a single amount to estimate SSP for items that are not sold separately, including on-premises licenses sold with SA or software updates provided at no additional charge. We use a range of amounts to estimate SSP when we sell each of the products and services separately and need to determine whether there is a discount to be allocated based on the relative SSP of the various products and services.

In instances where SSP is not directly observable, such as when we do not sell the product or service separately, we determine the SSP using information that may include market conditions and other observable inputs. We typically have more than one SSP for individual products and services due to the stratification of those products and services by customers and circumstances. In these instances, we may use information such as the size of the customer and geographic region in determining the SSP.

Due to the various benefits from and the nature of our SA program, judgment is required to assess the pattern of delivery, including the exercise pattern of certain benefits across our portfolio of customers.

Our products are generally sold with a right of return, we may provide other credits or incentives, and in certain instances we estimate customer usage of our products and services, which are accounted for as variable consideration when determining the amount of revenue to recognize. Returns and credits are estimated at contract inception and updated at the end of each reporting period if additional information becomes available. Changes to our estimated variable consideration were not material for the periods presented.

Impairment of Investment Securities

We review debt investments quarterly for credit losses and impairment. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, and the extent to which the fair value is less than cost. This determination requires significant judgment. In making this judgment, we employ a systematic methodology that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. In addition, we consider specific adverse conditions related to the financial health of, and business outlook for, the investee. If we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery, then a decline in fair value below cost is recorded as an impairment charge in other income (expense), net and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments.

Equity investments without readily determinable fair values are written down to fair value if a qualitative assessment indicates that the investment is impaired and the fair value of the investment is less than carrying value. We perform a qualitative assessment on a periodic basis. We are required to estimate the fair value of the investment to determine the amount of the impairment loss. Once an investment is determined to be impaired, an impairment charge is recorded in other income (expense), net.

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Goodwill

We allocate goodwill to reporting units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach. Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 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, or 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 primarily through the use of a discounted cash flow methodology. This analysis 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, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital.

The estimates used to calculate the fair value of a reporting unit change from year to year based on operating results, market conditions, and other factors. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit.

Research and Development Costs

Costs incurred internally in researching and developing a computer software product are charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, software costs are 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 after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to production. The amortization of these costs is included in cost of revenue over the estimated life of the products.

Legal and Other Contingencies

The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. An estimated loss from a loss contingency such as a legal proceeding or claim is 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. 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 consolidated financial statements.

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. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Accounting literature also provides guidance on derecognition of income tax assets and liabilities, classification of deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Judgment is required in assessing the future tax consequences of events that have been recognized in our consolidated financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our consolidated financial statements.

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Inventories

Inventories are stated at average cost, subject to the lower of cost or net realizable value. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. Net realizable value is the estimated selling price less estimated costs of completion, disposal, and transportation. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. These reviews include analysis of demand forecasts, product life cycle status, product development plans, current sales levels, pricing strategy, and component cost trends. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue.

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