Item 2. SUMMARY RESULTS OF OPERATIONS

SUMMARY RESULTS OF OPERATIONS

(In millions, except percentages and per share amounts)			Three Months Ended December 31,							Percentage Change				Six Months Ended December 31,								Percentage Change
			2022				2021								2022				2021
Revenue		$	52,747			$	51,728				2%			$	102,869			$	97,045				6%
Gross margin			35,259				34,768				1%				69,929				66,439				5%
Operating income			20,399				22,247				(8)%				41,917				42,485				(1)%
Net income			16,425				18,765				(12)%				33,981				39,270				(13)%
Diluted earnings per share			2.20				2.48				(11)%				4.54				5.19				(13)%
Adjusted gross margin (non-GAAP)			35,411				34,768				2%				70,081				66,439				5%
Adjusted operating income (non-GAAP)			21,570				22,247				(3)%				43,088				42,485				1%
Adjusted net income (non-GAAP)			17,371				18,765				(7)%				34,927				35,979				(3)%
Adjusted diluted earnings per share (non-GAAP)			2.32				2.48				(6)%				4.67				4.76				(2)%

Adjusted gross margin, operating income, net income, and diluted earnings per share (“EPS”) are non-GAAP financial measures. Current year non-GAAP financial measures exclude the impact of the Q2 charge, which includes employee severance expenses, impairment charges resulting from changes to our hardware portfolio, and costs related to lease consolidation activities. Prior year non-GAAP financial measures exclude the net income tax benefit related to transfer of intangible properties in the first quarter of fiscal year 2022. Refer to Note 11 – Income Taxes of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion. Refer to the Non-GAAP Financial Measures section below for a reconciliation of our financial results reported in accordance with GAAP to non-GAAP financial results.

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

Revenue increased $1.0 billion or 2% driven by growth in Intelligent Cloud and Productivity and Business Processes, offset in part by a decline in More Personal Computing. Intelligent Cloud revenue increased driven by Azure and other cloud services. Productivity and Business Processes revenue increased driven by Office 365 Commercial. More Personal Computing revenue decreased driven by declines in Windows, Devices, and Gaming.

Cost of revenue increased $528 million or 3% driven by growth in Microsoft Cloud, offset in part by a reduction in depreciation expense due to the change in accounting estimate for the useful lives of our server and network equipment.

Gross margin increased $491 million or 1% driven by growth in Intelligent Cloud and Productivity and Business Processes and the change in accounting estimate, offset in part by a decline in More Personal Computing.

	•	Gross margin percentage decreased slightly. Excluding the impact of the change in accounting estimate, gross margin percentage decreased 2 points driven by reductions in More Personal Computing and Intelligent Cloud, offset in part by sales mix shift.

	•	Microsoft Cloud gross margin percentage increased 2 points to 72%. Excluding the impact of the change in accounting estimate, Microsoft Cloud gross margin percentage decreased 1 point driven by sales mix shift to Azure and other cloud services and higher energy costs.

Operating expenses increased $2.3 billion or 19% driven by employee severance expenses, investments in cloud engineering, the Nuance acquisition, and LinkedIn.

Key changes in operating expenses were:

	•	Research and development expenses increased $1.1 billion or 19% driven by investments in cloud engineering, impairment charges resulting from changes to our hardware portfolio, and LinkedIn. Research and development included a favorable foreign currency impact of 2%.

	•	Sales and marketing expenses increased $300 million or 6% driven by the Nuance acquisition and investments in commercial sales. Sales and marketing included a favorable foreign currency impact of 3%.

	•	General and administrative expenses increased $953 million or 69% driven by employee severance expenses. General and administrative included a favorable foreign currency impact of 2%.

PART I

Item 2

Operating income decreased $1.8 billion or 8% driven by a decline in More Personal Computing, offset in part by the change in accounting estimate.

Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 5%, 7%, and 8%, respectively. Cost of revenue and operating expenses both included a favorable foreign currency impact of 2%.

Current year gross margin, operating income, net income, and diluted EPS were negatively impacted by the Q2 charge, which resulted in decreases of $152 million, $1.2 billion, $946 million, and $0.12, respectively.

Six Months Ended December 31, 2022 Compared with Six Months Ended December 31, 2021

Revenue increased $5.8 billion or 6% driven by growth in Intelligent Cloud and Productivity and Business Processes, offset in part by a decline in More Personal Computing. 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 decreased driven by declines in Windows, Devices, and Gaming, offset in part by growth in Search and news advertising.

Cost of revenue increased $2.3 billion or 8% driven by growth in Microsoft Cloud, offset in part by the change in accounting estimate.

Gross margin increased $3.5 billion or 5% driven by growth in Intelligent Cloud and Productivity and Business Processes and the change in accounting estimate, offset in part by a decline in More Personal Computing.

	•	Gross margin percentage decreased slightly. Excluding the impact of the change in accounting estimate, gross margin percentage decreased 2 points driven by reductions in More Personal Computing and Intelligent Cloud, offset in part by sales mix shift.

	•	Microsoft Cloud gross margin percentage increased 2 points to 72%. Excluding the impact of the change in accounting estimate, Microsoft Cloud gross margin percentage decreased 1 point driven by sales mix shift to Azure and other cloud services and higher energy costs.

Operating expenses increased $4.1 billion or 17% driven by investment in cloud engineering, employee severance expenses, LinkedIn, the Nuance acquisition, and commercial sales.

Key changes in operating expenses were:

	•	Research and development expenses increased $2.1 billion or 19% driven by investments in cloud engineering and LinkedIn.

	•	Sales and marketing expenses increased $879 million or 9% driven by investments in commercial sales and the Nuance acquisition. Sales and marketing included a favorable foreign currency impact of 4%.

	•	General and administrative expenses increased $1.1 billion or 40% driven by employee severance expenses. General and administrative included a favorable foreign currency impact of 3%.

Operating income decreased $568 million or 1% driven by a decline in More Personal Computing, offset in part by the change in accounting estimate and growth in Productivity and Business Processes and Intelligent Cloud.

Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 5%, 7%, and 8%, respectively. Cost of revenue and operating expenses included a favorable foreign currency impact of 2% and 3%, respectively.

Current year gross margin, operating income, net income, and diluted EPS were negatively impacted by the Q2 charge, which resulted in decreases of $152 million, $1.2 billion, $946 million, and $0.13, respectively. Prior 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.

PART I

Item 2

SEGMENT RESULTS OF OPERATIONS

(In millions, except percentages)		Three Months Ended December 31,								Percentage Change				Six Months Ended December 31,								Percentage Change
		2022				2021									2022				2021
Revenue
Productivity and Business Processes		$	17,002			$	15,936				7%			$	33,467			$	30,975				8%
Intelligent Cloud			21,508				18,262				18%				41,833				35,174				19%
More Personal Computing			14,237				17,530				(19)%				27,569				30,896				(11)%
Total		$	52,747			$	51,728				2%			$	102,869			$	97,045				6%
Operating Income
Productivity and Business Processes		$	8,175			$	7,688				6%			$	16,498			$	15,269				8%
Intelligent Cloud			8,904				8,323				7%				17,882				16,004				12%
More Personal Computing			3,320				6,236				(47)%				7,537				11,212				(33)%
Total		$	20,399			$	22,247				(8)%			$	41,917			$	42,485				(1)%

Reportable Segments

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

Productivity and Business Processes

Revenue increased $1.1 billion or 7%.

	•	Office Commercial products and cloud services revenue increased $627 million or 7%. Office 365 Commercial revenue grew 11% with seat growth of 12%, driven by small and medium business and frontline worker offerings, as well as growth in revenue per user. Office Commercial products revenue declined 30% driven by continued customer shift to cloud offerings.

	•	Office Consumer products and cloud services revenue decreased $39 million or 2%. Microsoft 365 Consumer subscribers grew 12% to 63.2 million.

	•	LinkedIn revenue increased $345 million or 10% driven by Talent Solutions.

	•	Dynamics products and cloud services revenue increased 13% driven by Dynamics 365 growth of 21%.

Operating income increased $487 million or 6%.

	•	Gross margin increased $1.0 billion or 8% driven by growth in Office 365 Commercial. Gross margin percentage increased. Excluding the impact of the change in accounting estimate, gross margin percentage decreased slightly driven by sales mix shift to cloud offerings.

	•	Operating expenses increased $554 million or 12% driven by investment in LinkedIn and employee severance expenses.

Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 6%, 8%, and 11%, respectively. Operating expenses included a favorable foreign currency impact of 2%.

Intelligent Cloud

Revenue increased $3.2 billion or 18%.

	•	Server products and cloud services revenue increased $3.2 billion or 20% driven by Azure and other cloud services. Azure and other cloud services revenue grew 31% driven by growth in our consumption-based services. Server products revenue decreased 2%.

	•	Enterprise Services revenue increased $39 million or 2% driven by growth in Enterprise Support Services, offset by a decline in Microsoft Consulting Services.

PART I

Item 2

Operating income increased $581 million or 7%.

	•	Gross margin increased $2.2 billion or 17% driven by growth in Azure and other cloud services and the change in accounting estimate. Gross margin percentage decreased slightly. Excluding the impact of the change in accounting estimate, gross margin percentage decreased 3 points driven by sales mix shift to Azure and other cloud services and higher energy costs.

	•	Operating expenses increased $1.6 billion or 34% driven by employee severance expenses, investments in Azure, and the Nuance acquisition.

Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 6%, 6%, and 8%, respectively. Operating expenses included a favorable foreign currency impact of 3%.

More Personal Computing

Revenue decreased $3.3 billion or 19%.

	•	Windows revenue decreased $1.8 billion or 27% driven by a decrease in Windows OEM. Windows OEM revenue decreased 39% on a strong prior year comparable, driven by continued PC market weakness and 3 points of negative impact from the prior year Windows 11 revenue deferral. Windows Commercial products and cloud services revenue decreased 3% driven by a decline in standalone product sales.

	•	Devices revenue decreased $927 million or 39% driven by continued PC market weakness and execution challenges on new product launches.

	•	Gaming revenue decreased $684 million or 13% driven by declines in Xbox content and services and Xbox hardware. Xbox content and services revenue decreased 12% on a strong prior year comparable impacted by first-party game launches, driven by declines in first-party content and a lower rate of monetization in third-party content, offset in part by growth in Xbox Game Pass subscriptions. Xbox hardware revenue decreased 13% driven by lower price and volume of consoles sold.

	•	Search and news advertising revenue increased $159 million or 5%. Search and news advertising revenue excluding traffic acquisition costs increased 10% driven by higher search volume and the Xandr acquisition, offset in part by lower revenue per search.

Operating income decreased $2.9 billion or 47%.

	•	Gross margin decreased $2.7 billion or 29% driven by declines in Windows and Devices. Gross margin percentage decreased driven by reductions in Devices, including the impact of impairment charges resulting from changes to our hardware portfolio, and sales mix shift to lower margin businesses.

	•	Operating expenses increased $198 million or 6% driven by employee severance expenses and investments in Search and news advertising, offset in part by a decline in Devices.

Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 3%, 5%, and 7%, respectively. Operating expenses included a favorable foreign currency impact of 3%.

Six Months Ended December 31, 2022 Compared with Six Months Ended December 31, 2021

Productivity and Business Processes

Revenue increased $2.5 billion or 8%.

	•	Office Commercial products and cloud services revenue increased $1.3 billion or 7%. Office 365 Commercial revenue grew 11% with seat growth of 12%, driven by small and medium business and frontline worker offerings, as well as growth in revenue per user. Office Commercial products revenue declined 29% driven by continued customer shift to cloud offerings.

	•	Office Consumer products and cloud services revenue increased $66 million or 2% with continued growth in Microsoft 365 Consumer subscription revenue.

	•	LinkedIn revenue increased $872 million or 13% driven by Talent Solutions.

	•	Dynamics products and cloud services revenue increased 14% driven by Dynamics 365 growth of 23%.

PART I

Item 2

Operating income increased $1.2 billion or 8%.

	•	Gross margin increased $2.4 billion or 10% driven by growth in Office 365 Commercial and LinkedIn. Gross margin percentage increased. Excluding the impact of the change in accounting estimate, gross margin percentage decreased slightly driven by sales mix shift to cloud offerings.

	•	Operating expenses increased $1.1 billion or 12% driven by investments in LinkedIn and cloud engineering, as well as employee severance expenses.

Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 6%, 7%, and 10%, respectively. Operating expenses included a favorable foreign currency impact of 3%.

Intelligent Cloud

Revenue increased $6.7 billion or 19%.

	•	Server products and cloud services revenue increased $6.5 billion or 21% driven by Azure and other cloud services. Azure and other cloud services revenue grew 33% driven by growth in our consumption-based services. Server products revenue decreased 1%.

	•	Enterprise Services revenue increased $124 million or 3% driven by growth in Enterprise Support Services, offset in part by a decline in Microsoft Consulting Services.

Operating income increased $1.9 billion or 12%.

	•	Gross margin increased $4.5 billion or 18% driven by growth in Azure and other cloud services and the change in accounting estimate. Gross margin percentage decreased slightly. Excluding the impact of the change in accounting estimate, gross margin percentage decreased 3 points driven by sales mix shift to Azure and other cloud services and higher energy costs.

	•	Operating expenses increased $2.7 billion or 30% driven by investments in Azure, the Nuance acquisition, and employee severance expenses.

Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 6%, 7%, and 8%, respectively. Operating expenses included a favorable foreign currency impact of 3%.

More Personal Computing

Revenue decreased $3.3 billion 11%.

	•	Windows revenue decreased $2.1 billion or 18% driven by a decrease in Windows OEM. Windows OEM revenue decreased 28% driven by continued PC market weakness. Windows Commercial products and cloud services revenue increased 2% driven by demand for Microsoft 365, offset in part by a decline in standalone product sales.

	•	Devices revenue decreased $893 million or 24% driven by continued PC market weakness and execution challenges on new product launches.

	•	Gaming revenue decreased $667 million or 7% driven by declines in Xbox content and services and Xbox hardware. Xbox content and services revenue decreased 8% driven by declines in first-party content and in third-party content, with lower rate of monetization and engagement hours, offset in part by growth in Xbox Game Pass subscriptions. Xbox hardware revenue decreased 5% driven by lower price of consoles sold.

	•	Search and news advertising revenue increased $431 million or 8%. Search and news advertising revenue excluding traffic acquisition costs increased 13% driven by higher search volume and the Xandr acquisition, offset in part by lower revenue per search.

Operating income decreased $3.7 billion or 33%.

	•	Gross margin decreased $3.4 billion or 20% driven by declines in Windows, Devices, and Gaming. Gross margin percentage decreased driven by reductions in Devices, including the impact of impairment charges resulting from changes to our hardware portfolio, and sales mix shift to lower margin businesses.

	•	Operating expenses increased $269 million or 4% driven by investment in Search and news advertising and employee severance expenses, offset in part by a decline in Devices.

PART I

Item 2

Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 3%, 5%, and 7%, respectively. Operating expenses included a favorable foreign currency impact of 3%.

OPERATING EXPENSES

Research and Development

(In millions, except percentages)		Three Months Ended December 31,								Percentage Change				Six Months Ended December 31,									Percentage Change
		2022				2021									2022					2021
Research and development		$	6,844			$	5,758				19%			$		13,472			$	11,357				19%
As a percent of revenue			13%				11%				2ppt				13%					12%				1ppt

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

Research and development expenses increased $1.1 billion or 19% driven by investments in cloud engineering, impairment charges resulting from changes to our hardware portfolio, and LinkedIn. Research and development included a favorable foreign currency impact of 2%.

Six Months Ended December 31, 2022 Compared with Six Months Ended December 31, 2021

Research and development expenses increased $2.1 billion or 19% driven by investments in cloud engineering and LinkedIn.

Sales and Marketing

(In millions, except percentages)		Three Months Ended December 31,								Percentage Change				Six Months Ended December 31,									Percentage Change
		2022				2021									2022					2021
Sales and marketing		$	5,679			$	5,379				6%			$		10,805			$	9,926				9%
As a percent of revenue			11%				10%				1ppt				11%					10%				1ppt

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

Sales and marketing expenses increased $300 million or 6% driven by the Nuance acquisition and investments in commercial sales. Sales and marketing included a favorable foreign currency impact of 3%.

Six Months Ended December 31, 2022 Compared with Six Months Ended December 31, 2021

Sales and marketing expenses increased $879 million or 9% driven by investments in commercial sales and the Nuance acquisition. Sales and marketing included a favorable foreign currency impact of 4%.

PART I

Item 2

General and Administrative

(In millions, except percentages)		Three Months Ended December 31,								Percentage Change				Six Months Ended December 31,									Percentage Change
		2022				2021									2022					2021
General and administrative		$	2,337			$	1,384				69%			$		3,735			$	2,671				40%
As a percent of revenue			4%				3%				1ppt				4%					3%				1ppt

General and administrative expenses include payroll, employee benefits, stock-based compensation expense, employee 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 December 31, 2022 Compared with Three Months Ended December 31, 2021

General and administrative expenses increased $953 million or 69% driven by employee severance expenses. General and administrative included a favorable foreign currency impact of 2%.

Six Months Ended December 31, 2022 Compared with Six Months Ended December 31, 2021

General and administrative expenses increased $1.1 billion or 40% driven by employee severance expenses. General and administrative included a favorable foreign currency impact of 3%.

OTHER INCOME (EXPENSE), NET

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

(In millions)		Three Months Ended December 31,								Six Months Ended December 31,
		2022				2021				2022				2021
Interest and dividends income		$	700			$	503			$	1,341			$	1,023
Interest expense			(490	)			(525	)			(990	)			(1,064	)
Net recognized gains (losses) on investments			(15	)			300				(2	)			671
Net gains (losses) on derivatives			(199	)			7				(190	)			0
Net losses on foreign currency remeasurements			(18	)			(13	)			(96	)			(78	)
Other, net			(38	)			(4	)			(69	)			2
Total		$	(60	)		$	268			$	(6	)		$	554

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

Interest and dividends income increased due to higher yields, offset in part by lower portfolio balances. 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. Net losses on derivatives increased due to losses on a forward purchase agreement for shares of the London Stock Exchange Group.

Six Months Ended December 31, 2022 Compared with Six Months Ended December 31, 2021

Interest and dividends income increased due to higher yields, offset in part by lower portfolio balances. 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 fixed income securities in the current period compared to gains in the prior period, and lower gains on equity securities in the current period. Net losses on derivatives increased due to losses on a forward purchase agreement for shares of the London Stock Exchange Group.

PART I

Item 2

INCOME TAXES

Effective Tax Rate

Our effective tax rate was 19% and 17% for the three months ended December 31, 2022 and 2021, respectively, and 19% and 9% for the six months ended December 31, 2022 and 2021, respectively. The increase in our effective tax rate for the three months ended December 31, 2022 compared to the prior year was primarily due to a decrease in tax benefits relating to stock-based compensation. The increase in our effective tax rate for the six months ended December 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 and a decrease in tax benefits relating to stock-based compensation.

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 exceeded 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 six months ended December 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.

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 December 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 2022, 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 gross margin, operating income, net income, and diluted EPS are non-GAAP financial measures. Current year non-GAAP financial measures exclude the impact of the Q2 charge, which includes employee severance expenses, impairment charges resulting from changes to our hardware portfolio, and costs related to lease consolidation activities. Prior year non-GAAP financial measures exclude the net income tax benefit related to transfer of intangible properties in the first quarter of fiscal year 2022. 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 December 31,						Percentage Change			Six Months Ended December 31,						Percentage Change
			2022			2021						2022			2021
Gross margin		$	35,259		$	34,768			1%		$	69,929		$	66,439			5%
Severance, hardware-related impairment, and lease consolidation costs			152			0			*			152			0			*
Adjusted gross margin (non-GAAP)		$	35,411		$	34,768			2%		$	70,081		$	66,439			5%
Operating income		$	20,399		$	22,247			(8)%		$	41,917		$	42,485			(1)%
Severance, hardware-related impairment, and lease consolidation costs			1,171			0			*			1,171			0			*
Adjusted operating income (non-GAAP)		$	21,570		$	22,247			(3)%		$	43,088		$	42,485			1%
Net income		$	16,425		$	18,765			(12)%		$	33,981		$	39,270			(13)%
Severance, hardware-related impairment, and lease consolidation costs			946			0			*			946			0			*
Net income tax benefit related to transfer of intangible properties			0			0			*			0			(3,291	)		*
Adjusted net income (non-GAAP)		$	17,371		$	18,765			(7)%		$	34,927		$	35,979			(3)%
Diluted earnings per share		$	2.20		$	2.48			(11)%		$	4.54		$	5.19			(13)%
Severance, hardware-related impairment, and lease consolidation costs			0.12			0			*			0.13			0			*
Net income tax benefit related to transfer of intangible properties			0			0			*			0			(0.43	)		*
Adjusted diluted earnings per share (non-GAAP)		$	2.32		$	2.48			(6)%		$	4.67		$	4.76			(2)%

*	Not meaningful.

LIQUIDITY AND CAPITAL RESOURCES

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 Tax Cuts and Jobs Act (“TCJA”), for at least the next 12 months and thereafter for the foreseeable future.

Cash, Cash Equivalents, and Investments

Cash, cash equivalents, and short-term investments totaled $99.5 billion and $104.8 billion as of December 31, 2022 and June 30, 2022, respectively. Equity investments were $7.1 billion and $6.9 billion as of December 31, 2022 and June 30, 2022, 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.

PART I

Item 2

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.

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 decreased $4.7 billion to $34.4 billion for the six months ended December 31, 2022, mainly due to an increase in cash paid to employees and suppliers and cash used to pay income taxes, offset in part by an increase in cash received from customers. Cash used in financing decreased $6.0 billion to $22.2 billion for the six months ended December 31, 2022, mainly due to a $4.1 billion decrease in common stock repurchases and a $3.1 billion decrease in repayments of debt. Cash used in investing increased $5.9 billion to $10.3 billion for the six months ended December 31, 2022, due to a $5.4 billion decrease in cash from net investment purchases, sales, and maturities, an $882 million increase in additions to property and equipment, and a $655 million increase in other investing to facilitate the purchase of components, offset in part by a $1.0 billion decrease in cash used for acquisitions of companies, net of cash acquired, and purchases of intangible and other assets.

Debt Proceeds

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. 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.

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

(In millions)
Three Months Ending
March 31, 2023		$	18,324
June 30, 2023			11,215
September 30, 2023			4,888
December 31, 2023			2,555
Thereafter			2,644
Total		$	39,626

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. Refer to Note 12 – Unearned Revenue of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion.

Material Cash Requirements and Other Obligations

Income Taxes

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 $7.7 billion, which included $1.5 billion during the six months ended December 31, 2022. The remaining transition tax of $10.5 billion is payable over the next three years, with $2.5 billion payable within 12 months.

Provisions enacted in the TCJA related to the capitalization for tax purposes of research and experimental expenditures became effective on July 1, 2022. These provisions require us to capitalize research and experimental expenditures and amortize them on the U.S. tax return over five or fifteen years, depending on where research is conducted. The final foreign tax credit regulations, also effective on July 1, 2022, introduced significant changes to foreign tax credit calculations in the U.S. tax return. While these provisions are not expected to have a material impact on our fiscal year 2023 effective tax rate on a net basis, our cash paid for taxes would increase unless these provisions are postponed or modified through legislative processes.

Share Repurchases

For the six months ended December 31, 2022 and 2021, we repurchased 37 million shares and 41 million shares of our common stock for $9.2 billion and $12.4 billion, respectively, through our share repurchase programs. All repurchases were made using cash resources. As of December 31, 2022, $31.5 billion remained of our $60 billion share repurchase program. 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

For the six months ended December 31, 2022 and 2021, our Board of Directors declared quarterly dividends of $0.68 per share and $0.62 per share, respectively. We intend to continue returning capital to shareholders in the form of dividends, subject to declaration by our Board of Directors. Refer to Note 15 – Stockholders’ Equity of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion.

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. The acquisition has been approved by Activision Blizzard’s shareholders. We are continuing to engage with regulators reviewing the transaction and are working toward closing it in fiscal year 2023, subject to obtaining required regulatory approvals and satisfaction of other customary closing conditions.

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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.

CRITICAL ACCOUNTING ESTIMATES

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. Critical accounting estimates are those estimates that involve a significant level of estimation uncertainty and could have a material impact on our financial condition or results of operations. We have critical accounting estimates in the areas of 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.

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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.

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.

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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.

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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