Microsoft 2002 Annual Report Download - page 37

MSFT 39 / 2002 FORM 10-K
Part II
Item 8
INCOME TAXES
Income tax expense includes U.S. and international income taxes, plus the provision for U.S. taxes on undistributed earnings of international subsidiaries not
deemed to be permanently invested. Certain items of income and expense are not reported in tax returns and financial statements in the same year. The tax
effect of this difference is reported as deferred income taxes.
FINANCIAL INSTRUMENTS
The Company considers all liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. Short-
term investments generally mature between three months and six years from the purchase date. Investments with maturities beyond one year may be
classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for
current operations. All cash and short-term investments are classified as available for sale and are recorded at market value using the specific identification
method; unrealized gains and losses are reflected in OCI.
Equity and other investments include debt and equity instruments. Debt securities and publicly traded equity securities are classified as available for sale
and are recorded at market using the specific identification method. Unrealized gains and losses (excluding other-than-temporary impairments) are reflected
in OCI. All other investments, excluding those accounted for using the equity method, are recorded at cost.
Microsoft lends certain fixed income and equity securities to enhance investment income. Collateral and/or security interest is determined based upon the
underlying security and the creditworthiness of the borrower. The fair value of collateral that Microsoft is permitted to sell or repledge was $499 million at both
June 30, 2001 and 2002.
Investments are considered to be impaired when a decline in fair value is judged to be other-than-temporary. The Company employs a systematic
methodology that considers available evidence in evaluating potential impairment of its investments. In the event that the cost of an investment exceeds its
fair value, the Company evaluates, among other factors, the duration and extent to which the fair value is less than cost; 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; and the
Company’s intent and ability to hold the investment. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded
and a new cost basis in the investment is established. In 2001, the Company recognized $4.80 billion in impairments of certain investments, primarily in the
cable and telecommunication industries. In 2002, Microsoft recognized $4.32 billion in impairments of certain investments, primarily related to further declines
in the fair values of U.S. and European cable and telecommunications holdings.
The Company uses derivative instruments to manage exposures to foreign currency, security price, and interest rate risks. The Company’s objectives for
holding derivatives are to minimize these risks using the most effective methods to eliminate or reduce the impact of these exposures.
Foreign Currency Risk. Certain forecasted transactions and assets are exposed to foreign currency risk. The Company monitors its foreign currency
exposures daily to maximize the overall effectiveness of its foreign currency hedge positions. Principal currencies hedged include the Euro, Japanese yen,
British pound, and Canadian dollar. Options used to hedge a portion of forecasted international revenue for up to three years in the future are designated as
cash flow hedging instruments. Options and forwards not designated as hedging instruments under SFAS 133 are also used to hedge the impact of the
variability in exchange rates on accounts receivable and collections denominated in certain foreign currencies.
Securities Price Risk. Strategic equity investments are subject to market price risk. From time to time, the Company uses and designates options to
hedge fair values and cash flows on certain equity securities. The security, or forecasted sale thereof, selected for hedging is determined by market
conditions, up-front costs, and other relevant factors. Once established, the hedges are not dynamically managed or traded, and are generally not removed
until maturity.
Interest Rate Risk. Fixed-income securities are subject to interest rate risk. The fixed-income portfolio is diversified and consists primarily of investment
grade securities to minimize credit risk. The Company routinely uses options, not designated as hedging instruments, to hedge its exposure to interest rate
risk in the event of a catastrophic increase in interest rates.
Other Derivatives. In addition, the Company may invest in warrants to purchase securities of other companies as a strategic investment. Warrants that can
be net share settled are deemed derivative financial instruments and are not designated as hedging instruments.
For options designated either as fair value or cash flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
The allowance for doubtful accounts reflects management’s best estimate of probable losses inherent in the account receivable balance. Management
determines the allowance based on known troubled accounts, historical experience, and other currently available evidence. Activity in the allowance for
doubtful accounts is as follows:
In millions
Year Ended June 30
Balance at
Beginning of Period
Charged to Costs
and Expenses
Write-
offs
and
Othe
r
Balance at
End of Period
2002 $174 $192 $ 157 $209
2001 186 157 169 174
2000 204 77 95 186