How do Apple and Microsoft make money

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.

Fiscal Year 2020 Compared with Fiscal Year 2019

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Interest and dividends income decreased due to lower yields, offset in part by higher average portfolio balances on fixed-income securities. Interest expense decreased due to capitalization of interest expense and a decrease in outstanding long-term debt due to debt maturities, offset in part by debt exchange transaction fees and higher finance lease expense. Net recognized gains on investments decreased due to lower gains and higher other-than-

temporary impairments on equity investments, offset in part by gains on fixed income securities in the current period compared to losses in the prior period. Net gains on derivatives increased due to higher gains on foreign exchange and equity derivatives.

Fiscal Year 2019 Compared with Fiscal Year 2018

Interest and dividends income increased primarily due to higher yields on fixed-income securities. Interest expense decreased primarily driven by a decrease in outstanding long-term debt due to debt maturities, offset in part by higher finance lease expense. Net recognized gains on investments decreased primarily due to lower gains on sales of equity investments. Net gains on derivatives includes gains on foreign exchange and interest rate derivatives in the current period as compared to losses in the prior period.

INCOME TAXES

Effective Tax Rate

Fiscal Year 2020 Compared with Fiscal Year 2019

Our effective tax rate for fiscal years 2020 and 2019 was 17% and 10%, respectively. The increase in our effective tax rate for fiscal year 2020 compared to fiscal year 2019 was primarily due to a $2.6 billion net income tax benefit in the fourth quarter of fiscal year 2019 related to intangible property transfers. Our effective tax rate was lower than the U.S. federal statutory rate, 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 centers in Ireland and Puerto Rico, and tax benefits relating to stock-based compensation.

The mix of income before income taxes between the U.S. and foreign countries impacted our effective tax rate as a result of the geographic distribution of, and customer demand for, our products and services. In fiscal year 2020, our U.S. income before income taxes was $24.1 billion and our foreign income before income taxes was $28.9 billion. In fiscal year 2019, our U.S. income before income taxes was $15.8 billion and our foreign income before income taxes was $27.9 billion.

Fiscal Year 2019 Compared with Fiscal Year 2018

Our effective tax rate for fiscal years 2019 and 2018 was 10% and 55%, respectively. The decrease in our effective tax rate for fiscal year 2019 compared to fiscal year 2018 was primarily due to the net charge related to the enactment of the TCJA in the second quarter of fiscal year 2018 and a $2.6 billion net income tax benefit in the fourth quarter of fiscal year 2019 related to intangible property transfers. Our effective tax rate was lower than the U.S. federal statutory rate, primarily due to the tax benefit related to intangible property transfers, and earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico.

The mix of income before income taxes between the U.S. and foreign countries impacted our effective tax rate as a result of the geographic distribution of, and customer demand for, our products and services. In fiscal year 2019, our U.S. income before income taxes was $15.8 billion and our foreign income before income taxes was $27.9 billion. In fiscal year 2018, our U.S. income before income taxes was $11.5 billion and our foreign income before income taxes was $24.9 billion.

Tax Cuts and Jobs Act

On December 22, 2017, the TCJA was enacted into law, which significantly changed existing U.S. tax law and included numerous provisions that affect our business. We recorded a provisional net charge of $13.7 billion related to the enactment of the TCJA in fiscal year 2018, and adjusted the provisional net charge by recording additional tax expense of $157 million in fiscal year 2019 pursuant to Securities and Exchange Commission Staff Accounting Bulletin No. 118.

In fiscal year 2019, in response to the TCJA and recently issued regulations, we transferred certain intangible properties held by our foreign subsidiaries to the U.S. and Ireland. The transfers of intangible properties resulted in a $2.6 billion net income tax benefit recorded in the fourth quarter of fiscal year 2019, as the value of future tax deductions exceeded the current tax liability from foreign jurisdictions and U.S. global intangible low-taxed income tax.

Refer to Note 12 – Income Taxes of the Notes to Financial Statements for further discussion.

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. We remain under audit for tax years 2004 to 2013. In April 2020, the IRS commenced the audit for tax years 2014 to 2017.

As of June 30, 2020, 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 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 2019, 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

Non-GAAP net income and diluted EPS are non-GAAP financial measures which exclude the net tax impact of transfer of intangible properties in fiscal year 2019 and the net tax impact of the TCJA in fiscal years 2019 and 2018. 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.

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)202020192018Percentage
Change 2020
Versus 2019
Percentage
Change 2019
Versus 2018
 
Net income$   44,281$ 39,240  $ 16,571  13%137%
Net tax impact of transfer of intangible properties0(2,567 )   0**
Net tax impact of the TCJA0   157   13,696**
  
Non-GAAP net income$ 44,281$ 36,830$ 30,26720%22%
   
Diluted earnings per share$ 5.76$ 5.06$ 2.1314%138%
Net tax impact of transfer of intangible properties0(0.33 )   0**
Net tax impact of the TCJA0   0.02   1.75**
  
Non-GAAP diluted earnings per share$ 5.76$ 4.75$ 3.8821%22%
     

Not meaningful.

FINANCIAL CONDITION

Cash, Cash Equivalents, and Investments

Cash, cash equivalents, and short-term investments totaled $136.5 billion and $133.8 billion as of June 30, 2020 and 2019. Equity investments were $3.0 billion and $2.6 billion as of June 30, 2020 and 2019, 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.

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

Fiscal Year 2020 Compared with Fiscal Year 2019

Cash from operations increased $8.5 billion to $60.7 billion for fiscal year 2020, mainly due to an increase in cash from customers, offset in part by an increase in cash used to pay income taxes, suppliers, and employees. Cash used in financing increased $9.1 billion to $46.0 billion for fiscal year 2020, mainly due to a $3.4 billion cash premium on our debt exchange, a $3.4 billion increase in common stock repurchases, a $1.5 billion increase in repayments of debt, and a $1.3 billion increase in dividends paid. Cash used in investing decreased $3.6 billion to $12.2 billion for fiscal year 2020, mainly due to a $6.4 billion increase in cash from net investment purchases, sales, and maturities, offset in part by a $1.5 billion increase in additions to property and equipment and $1.2 billion in other investing to facilitate the purchase of components.

Fiscal Year 2019 Compared with Fiscal Year 2018

Cash from operations increased $8.3 billion to $52.2 billion for fiscal year 2019, mainly due to an increase in cash received from customers, offset in part by an increase in cash paid to suppliers and employees and an increase in

cash paid for income taxes. Cash used in financing increased $3.3 billion to $36.9 billion for fiscal year 2019, mainly due to an $8.8 billion increase in common stock repurchases and a $1.1 billion increase in dividends paid, offset in part by a $6.2 billion decrease in repayments of debt, net of proceeds from issuance of debt. Cash used in investing increased $9.7 billion to $15.8 billion for fiscal year 2019, mainly due to a $6.0 billion decrease in cash from net investment purchases, sales, and maturities, a $2.3 billion increase in additions to property and equipment, and a $1.5 billion increase in cash used for acquisitions of companies, net of cash acquired, and purchases of intangible and other assets.

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 June 2020, we exchanged a portion of our existing debt at 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 11 – Debt of the Notes to Financial Statements 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. Refer to Note 1 – Accounting Policies of the Notes to Financial Statements for further discussion.

The following table outlines the expected future recognition of unearned revenue as of June 30, 2020:

(In millions) 
 
  
Three Months Ending 
  
September 30, 2020$   13,884
December 31, 202010,950
March 31, 20217,476
June 30, 20213,690
Thereafter3,180
Total$ 39,180
 

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.

Share Repurchases

For fiscal years 2020, 2019, and 2018, we repurchased 126 million shares, 150 million shares, and 99 million shares of our common stock for $19.7 billion, $16.8 billion, and $8.6 billion, respectively, through our share repurchase programs. All repurchases were made using cash resources. Refer to Note 16 – Stockholders’ Equity of the Notes to Financial Statements for further discussion.

Dividends

Refer to Note 16 – Stockholders’ Equity of the Notes to Financial Statements 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.

Contractual Obligations

The following table summarizes the payments due by fiscal year for our outstanding contractual obligations as of June 30, 2020:

(In millions)20212022-20232024-2025ThereafterTotal
 
Long-term debt:  (a)
Principal payments$ 3,750$ 10,716$ 7,500$ 45,441$ 67,407
Interest payments2,0283,7363,29325,26534,322
Construction commitments  (b)4,761280005,041
Operating leases, including imputed interest  (c)2,4203,9862,9294,40913,744
Finance leases, including imputed interest  (c)9922,2432,6769,61115,522
Transition tax  (d)1,4502,8996,3434,53115,223
Purchase commitments  (e)25,0591,32436927227,024
Other long-term liabilities  (f)029432356682
Total$   40,460$   25,478$   23,142$   89,885$   178,965
 

(a) Refer to Note 11 – Debt of the Notes to Financial Statements.

(b) Refer to Note 7 – Property and Equipment of the Notes to Financial Statements.

(c) Refer to Note 14 – Leases of the Notes to Financial Statements.

(d) Refer to Note 12 – Income Taxes of the Notes to Financial Statements.

(e) Amounts represent purchase commitments, including open purchase orders and take-or-pay contracts that are not presented as construction commitments above.

(f) We have excluded long-term tax contingencies, other tax liabilities, and deferred income taxes of $15.2 billion from the amounts presented as the timing of these obligations is uncertain. We have also excluded unearned revenue and non-cash items.

Other Planned Uses of Capital

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, retail stores, 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 $3.2 billion, which included $1.2 billion for fiscal year 2020. The remaining transition tax of $15.2 billion is payable over the next six years with a final payment in fiscal year 2026. During fiscal year 2020, we also paid $3.7 billion related to the transfer of intangible properties that occurred in the fourth quarter of fiscal year 2019.

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 for further discussion.

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 the recent outbreak of COVID-19. Critical accounting policies for us include revenue recognition, impairment of investment securities, goodwill, research and development costs, 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 indicators of other-than-temporary impairment. This determination requires significant judgment. In making this judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, and the duration and extent to which the fair value is less than cost. We also evaluate whether 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. In addition, we consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded 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 quarterly 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.

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.

The TCJA significantly changes existing U.S. tax law and includes numerous provisions that affect our business. Refer to Note 12 – Income Taxes of the Notes to Financial Statements for further discussion.

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.

CHANGE IN ACCOUNTING ESTIMATE

In July 2020, we completed an assessment of the useful lives of our server and network equipment and determined we should increase the estimated useful life of server equipment from three years to four years and increase the estimated useful life of network equipment from two years to four years. This change in accounting estimate will be effective beginning fiscal year 2021. Based on the carrying amount of server and network equipment included in “Property and equipment, net” as of June 30, 2020, it is estimated this change will increase our fiscal year 2021 operating income by $2.7 billion.

STATEMENT OF MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL STATEMENTS

Management is responsible for the preparation of the consolidated financial statements and related information that are presented in this report. The consolidated financial statements, which include amounts based on management’s estimates and judgments, have been prepared in conformity with accounting principles generally accepted in the United States of America.

The Company designs and maintains accounting and internal control systems to provide reasonable assurance at reasonable cost that assets are safeguarded against loss from unauthorized use or disposition, and that the financial records are reliable for preparing consolidated financial statements and maintaining accountability for assets. These systems are augmented by written policies, an organizational structure providing division of responsibilities, careful selection and training of qualified personnel, and a program of internal audits.

The Company engaged Deloitte & Touche LLP, an independent registered public accounting firm, to audit and render an opinion on the consolidated financial statements and internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States).

The Board of Directors, through its Audit Committee, consisting solely of independent directors of the Company, meets periodically with management, internal auditors, and our independent registered public accounting firm to ensure that each is meeting its responsibilities and to discuss matters concerning internal controls and financial reporting. Deloitte & Touche LLP and the internal auditors each have full and free access to the Audit Committee.

Satya Nadella

Chief Executive Officer

Amy E. Hood

Executive Vice President and Chief Financial Officer

Frank H. Brod

Corporate Vice President, Finance and Administration;

Chief Accounting Officer

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

RISKS

We are exposed to economic risk from foreign exchange rates, interest rates, credit risk, and equity prices. We use derivatives instruments to manage these risks, however, they may still impact our consolidated financial statements.

Foreign Currencies

Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency positions, including hedges. Principal currency exposures include the Euro, Japanese yen, British pound, Canadian dollar, and Australian dollar.

Interest Rate

Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of the fixed-income portfolio to achieve economic returns that correlate to certain global fixed-income indices.

Credit

Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We manage credit exposures relative to broad-based indices and to facilitate portfolio diversification.

Equity

Securities held in our equity investments portfolio are subject to price risk.

SENSITIVITY ANALYSIS

The following table sets forth the potential loss in future earnings or fair values, including associated derivatives, resulting from hypothetical changes in relevant market rates or prices:

(In millions)   
 
    
Risk CategoriesHypothetical ChangeJune 30,2020Impact
    
Foreign currency – Revenue10% decrease in foreign exchange rates$   (4,142 )Earnings
Foreign currency – Investments10% decrease in foreign exchange rates(119 )Fair Value
Interest rate100 basis point increase in U.S. treasury interest rates(3,951 )Fair Value
Credit100 basis point increase in credit spreads(301 )Fair Value
Equity10% decrease in equity market prices(239 )Earnings
 

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

INCOME STATEMENTS

(In millions, except per share amounts)   
 
    
Year Ended June 30,202020192018
 
Revenue:
Product$ 68,041$ 66,069$ 64,497
Service and other74,97459,77445,863
Total revenue143,015125,843110,360
Cost of revenue:
Product16,01716,27315,420
Service and other30,06126,63722,933
Total cost of revenue46,07842,91038,353
Gross margin96,93782,93372,007
Research and development19,26916,87614,726
Sales and marketing19,59818,21317,469
General and administrative5,1114,8854,754
Operating income52,95942,95935,058
Other income, net777291,416
Income before income taxes53,03643,68836,474
Provision for income taxes8,7554,44819,903
Net income$ 44,281$ 39,240$ 16,571
 
 
Earnings per share:
Basic$ 5.82$ 5.11$ 2.15
Diluted$ 5.76$ 5.06$ 2.13
 
Weighted average shares outstanding:
Basic7,6107,6737,700
Diluted7,6837,7537,794

Refer to accompanying notes.

COMPREHENSIVE INCOME STATEMENTS

(In millions)   
 
    
Year Ended June 30,202020192018
    
Net income$   44,281$   39,240$   16,571
    
Other comprehensive income (loss), net of tax:   
Net change related to derivatives(38 )(173 )   39
Net change related to investments   3,990   2,405(2,717 )
Translation adjustments and other(426 )(318 )(178 )
   
Other comprehensive income (loss)   3,526   1,914(2,856 )
   
Comprehensive income$ 47,807$ 41,154$ 13,715
    

Refer to accompanying notes.

BALANCE SHEETS

(In millions)  
 
   
June 30,20202019
   
Assets  
Current assets:  
Cash and cash equivalents$ 13,576$ 11,356
Short-term investments   122,951   122,463
  
Total cash, cash equivalents, and short-term investments   136,527   133,819
Accounts receivable, net of allowance for doubtful accounts of $788 and $411   32,011   29,524
Inventories   1,895   2,063
Other current assets   11,482   10,146
  
Total current assets   181,915   175,552
Property and equipment, net of accumulated depreciation of $43,197 and $35,330   44,151   36,477
Operating lease right-of-use assets   8,753   7,379
Equity investments   2,965   2,649
Goodwill   43,351   42,026
Intangible assets, net   7,038   7,750
Other long-term assets   13,138   14,723
  
Total assets$   301,311$   286,556
   
Liabilities and stockholders’ equity  
Current liabilities:  
Accounts payable$ 12,530$ 9,382
Current portion of long-term debt   3,749   5,516
Accrued compensation   7,874   6,830
Short-term income taxes   2,130   5,665
Short-term unearned revenue   36,000   32,676
Other current liabilities   10,027   9,351
  
Total current liabilities   72,310   69,420
Long-term debt   59,578   66,662
Long-term income taxes   29,432   29,612
Long-term unearned revenue   3,180   4,530
Deferred income taxes   204   233
Operating lease liabilities   7,671   6,188
Other long-term liabilities   10,632   7,581
  
Total liabilities   183,007   184,226
  
Commitments and contingencies  
Stockholders’ equity:  
Common stock and paid-in capital – shares authorized 24,000; outstanding 7,571 and 7,643   80,552   78,520
Retained earnings   34,566   24,150
Accumulated other comprehensive income (loss)   3,186(340)
  
Total stockholders’ equity   118,304   102,330
  
Total liabilities and stockholders’ equity$ 301,311$ 286,556
   

Refer to accompanying notes.

CASH FLOWS STATEMENTS

(In millions)   
 
    
Year Ended June 30,202020192018
    
Operations   
Net income$ 44,281$ 39,240$ 16,571
Adjustments to reconcile net income to net cash from operations:   
Depreciation, amortization, and other   12,796   11,682   10,261
Stock-based compensation expense   5,289   4,652   3,940
Net recognized gains on investments and derivatives(219 )(792 )(2,212 )
Deferred income taxes   11(6,463 )(5,143 )
Changes in operating assets and liabilities:   
Accounts receivable(2,577 )(2,812 )(3,862 )
Inventories   168   597(465 )
Other current assets(2,330 )(1,718 )(952 )
Other long-term assets(1,037 )(1,834 )(285 )
Accounts payable   3,018   232   1,148
Unearned revenue   2,212   4,462   5,922
Income taxes(3,631 )   2,929   18,183
Other current liabilities   1,346   1,419   798
Other long-term liabilities   1,348   591(20 )
   
Net cash from operations   60,675   52,185   43,884
   
Financing   
Repayments of short-term debt, maturities of 90 days or less, net   0   0(7,324 )
Proceeds from issuance of debt   0   0   7,183
Cash premium on debt exchange(3,417 )   0   0
Repayments of debt(5,518 )(4,000 )(10,060 )
Common stock issued   1,343   1,142   1,002
Common stock repurchased(22,968 )(19,543 )(10,721 )
Common stock cash dividends paid(15,137 )(13,811 )(12,699 )
Other, net(334 )(675 )(971 )
   
Net cash used in financing(46,031 )(36,887 )(33,590 )
   
Investing   
Additions to property and equipment(15,441 )(13,925 )(11,632 )
Acquisition of companies, net of cash acquired, and purchases of intangible and other assets(2,521 )(2,388 )(888 )
Purchases of investments(77,190 )(57,697 )(137,380 )
Maturities of investments   66,449   20,043   26,360
Sales of investments   17,721   38,194   117,577
Other, net(1,241 )   0(98 )
   
Net cash used in investing(12,223 )(15,773 )(6,061 )
   
Effect of foreign exchange rates on cash and cash equivalents(201 )(115 )   50
   
Net change in cash and cash equivalents   2,220(590 )   4,283
Cash and cash equivalents, beginning of period   11,356   11,946   7,663
   
Cash and cash equivalents, end of period$ 13,576$ 11,356$ 11,946
    

Refer to accompanying notes.

STOCKHOLDERS’ EQUITY STATEMENTS

(In millions)   
 
    
Year Ended June 30,202020192018
    
Common stock and paid-in capital   
Balance, beginning of period$ 78,520$ 71,223$ 69,315
Common stock issued       1,343       6,829       1,002
Common stock repurchased(4,599 )(4,195 )(3,033 )
Stock-based compensation expense       5,289       4,652       3,940
Other, net(1 )       11(1 )
   
Balance, end of period       80,552       78,520       71,223
   
Retained earnings   
Balance, beginning of period       24,150       13,682       17,769
Net income       44,281       39,240       16,571
Common stock cash dividends(15,483 )(14,103 )(12,917 )
Common stock repurchased(18,382 )(15,346 )(7,699 )
Cumulative effect of accounting changes       0       677(42 )
   
Balance, end of period       34,566       24,150       13,682
   
Accumulated other comprehensive income (loss)   
Balance, beginning of period(340 )(2,187 )       627
Other comprehensive income (loss)       3,526       1,914(2,856 )
Cumulative effect of accounting changes       0(67 )       42
   
Balance, end of period       3,186(340 )(2,187 )
   
Total stockholders’ equity$   118,304$   102,330$  82,718
    
    
Cash dividends declared per common share$ 2.04$ 1.84$ 1.68
 

Refer to accompanying notes.

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