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Accounting for iPhone at Apple Inc On October 21, 2008, AppleInc. announced financial results...

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Accounting for iPhone at Apple Inc On October 21, 2008, AppleInc. announced financial results for Q4 of FY 2008 ended September27, 2008 (see Exhibit 1). Under the U.S. generally acceptedaccounting principles (GAAP), Apple reported quarterly revenue of$7.9 billion and net profit of $1.1 billion. For the first time,the Cupertino, California-based company included non-GAAP measuresin its earnings announcement to supplement its U.S. GAAP financialresults. Apple’s non-GAAP quarterly revenue and net profit were$11.7 billion and $2.4 billion, respectively. As Apple CEO SteveJobs noted, “As you can see, the non-GAAP financial results aretruly stunning.”1 He explained the change in a rare appearance onthe company’s earnings conference call later that day: I would liketo . . . talk about the non-GAAP financial results, because I thinkthis is a pretty big deal. In addition to reporting an outstandingquarter, today we are also introducing non- GAAP financial results,which eliminate the impact of subscription accounting. Because byits nature subscription accounting spreads the impact of iPhone’scontribution to Apple’s overall sales, gross margin, and net incomeover two years, it can make it more difficult for the average Applemanager or the average investor to evaluate the company’s overallperformance. As long as our iPhone business was small relative toour Mac and music businesses, this didn’t really matter much, butthe past quarter, as you heard, our iPhone business has grown toabout $4.6 billion, or 39% of Apple’s total business, clearly toobig for Apple management or investors to ignore.2 Jobs also notedthat in terms of non-GAAP mobile-phone revenue, in just 15 monthsApple had become the world’s third-largest phone manufacturerbehind Nokia and Samsung but ahead of Sony Ericsson, LG, Motorola,and RIM. Company Background Jobs and Steve Wozniak launched thepersonal computer revolution in the 1970s with the Apple II. In1984, the Apple Macintosh, with its ease-of-use and brilliantdesign, redefined the personal computer. Shortly thereafter, Jobsleft the company, returning in 1997. Under Jobs, Apple catalyzedthe digital-media industry with the launch of its iPod portablemusical player in October 2001, followed by the introduction of itsiTunes online store in April 2003. In June 2007, the companyentered the highly competitive mobile-phone market with its iPhone,the first smartphone (a combination of a phone and a mini-computer)with a touch-screen interface and the company’s new mobileoperating system, iOS. Several months later, Apple released theiPod touch (an iPhone without the phone capability). Apple releasedits iPhone 3G in July 2008 along with its second-generation mobileoperating system (iOS 2). Also in July 2008, Apple introduced itsApp Store, which offered iPhone and iPod touch users a wide varietyof mobile applications ranging from games to social networking toproductivity tools, mostly priced under $10. On July 14, 2008, Jobsnoted, “The App Store is a grand slam, with a staggering 10 millionapplications downloaded in just three days. Developers have createdsome extraordinary applications, and the App Store can wirelesslydeliver them to every iPhone and iPod touch user instantly.”3 Manyof the applications took advantage of the more robust iOS 2. ByOctober 2008, Apple was best known for its technical and designinnovation, its “walled garden” approach (i.e., its mostlyproprietary ecosystem of hardware, operating and applicationsoftware, and peripherals), and its premium-priced products. iPhoneBusiness Model The original iPhone 8GB model had a U.S. retailprice of $399 and was available through Apple and AT&T, theiPhone’s exclusive U.S. mobile carrier. In the U.S., mobilecarriers typically provided subsidies to phone manufacturers, whichlowered the purchase price of the new phone. In exchange, mostconsumers signed a two-year service contract with the carriers.Apple and AT&T agreed to a different arrangement, but did notdisclose its specifics. AT&T did not subsidize the iPhone;instead, Apple signed a revenue-sharing agreement with AT&Tthat gave Apple a share of the subscribers’ monthly service fees.Needham & Co. analyst Charles Wolf believed that AT&T paidApple $10 per month over a typical two-year contract.4 In addition,although Apple did not disclose how much it sold the iPhone for toAT&T, analysts believed that Apple made an estimated $120 ingross profit on every iPhone sold.5 At the iPhone’s launch, Appleannounced it might periodically offer new software updates andupgrades free of charge to its iPhone customers. In contrast, Macand iPod users did not receive free software features and upgrades.For example, users were charged $129 to upgrade to the new Macoperating system (Mac OS X Leopard) in October 2007, whereas Appleplanned to provide newer versions of the iPhone operating systemfree of charge to all iPhone users. Apple’s chief financial officerPeter Oppenheimer explained, “Since iPhone customers will likely beour best advocates for the product, we want to get them many ofthese new features and applications at no additional charge as theybecome available.”6 In addition, Apple’s management knew thatsmartphone users were slow to update their software, and that fewopted to buy upgrades. Therefore, the company believed it wasnecessary to offer new software features free of charge to increaseuser acceptance. In contrast, most other mobile software vendorsreserved new software updates for new hardware (i.e., phone)releases.7 Apple, AT&T, third-party application developers, andusers would all benefit from consumers’ use of the latest operatingsystem and applications, giving Apple and its ecosystem acompetitive advantage. AT&T would run a more effective andefficient mobile network; third-party software developers wouldhave a stable hardware and software roadmap; Apple could delistapplications from its App Store that weren’t written for its latestoperating system; and all the while, iPhone users would benefitfrom an evolving and differentiated set of features andfunctionality. Many users ofcompeting mobile-phone platforms couldnot upgrade to newer operating systems and applications because ofcompatibility issues with their phones. When Apple launched theiPhone 3G in July 2008, it revamped its business model, bringing itmore in line with industry practices. Apple gave up its share ofthe monthly service revenue in exchange for AT&T subsidizingthe price of the iPhone 3G, which sold for $199 at retail. Again,the two parties chose not to disclose the specifics of theirarrangement, but the subsidy was estimated at $300 per phone sold.8Apple continued to differ from most other industry participantswhen it offered existing iPhone users upgrades to itssecond-generation operating system at no cost. By August 2008, amonth after Apple introduced its App Store, Jobs noted that usersdownloaded more than 60 million programs for the iPhone, and Applewas averaging $1 million a day in application-software revenue.Apple received 30% of the App Store revenue from the sale of aniPhone application, and the developer received the remaining 70%.9Jobs stated, “Phone differentiation used to be about radios andantennas and things like that. We think, going forward, the phoneof the future will be differentiated by software.”10 Also in August2008, the New York Times reported that T-Mobile would be the firstcarrier to launch mobile phones using Google’s Android mobileoperating system; the phones were expected to hit shelves in lateOctober 2008. On October 21, 2008, Google announced that Androidwas now “the first free, open source, and fully customizable mobileplatform.” iPhone Revenue Recognition Software-enabled hardwaredevices (also known as “bundled components”), such as Apple’siPhone, Macs, and iPods, fell under the software revenuerecognition rules pursuant to American Institute of CertifiedPublic Accountants (AICPA) Statement of Position (SOP) No. 97-2,Software Revenue Recognition. When Apple first introduced theiPhone in 2007, the company announced it would use the“subscription method of accounting” under SOP No. 97-2 to bookrevenue for its new iPhone. Oppenheimer explained: Since we will beperiodically providing new software features to iPhone customersfree of charge, we will use subscription accounting and recognizethe revenue and product cost of goods sold associated with iPhonehandset sales on a straight line basis over 24 months. So while thecash from iPhone sales will be collected at the time of sale, wewill be recording deferred revenue and costs of goods sold on ourbalance sheet, and amortizing both of them into our earnings on astraight line basis over 24 months. We will continue to expense ouriPhone engineering, sales, and marketing costs as we incur them.This accounting policy will have no impact on cash flow or theeconomics of our business.12 In contrast, Apple generallyrecognized revenue and cost of sales for its other software-enabledhardware products such as Macs and iPods at the time of sale (i.e.,immediate revenue recognition) under SOP No. 97-2. This was becausethe company did not provide new features or software applicationsfor those products free of charge. (See Exhibit 2 for the FY 2008financial statement note relating to Apple’s revenue recognitionpolicies under GAAP.) Apple’s decision to use subscriptionaccounting for the iPhone came soon after the company facedconsumer backlash over a $5 upgrade fee (later reduced to $1.99) itcharged new MacBook buyers.13 In 2006, Apple sold its latestMacBook with a wireless chip that would allow users to access thenew and better Wi-Fi 802.11n technology once it became availableand the chip was activated withsoftware. Apple did not tell MacBookbuyers about the chip’s existence, and it also recognized allrevenue at the time the MacBooks sold. Thus, the chip and itsactivation software were an unspecified, future upgrade that didnot have an established, objective, separate value (which wouldhave allowed it to be accounted for separately) at the time of theMacBook sale. To comply with GAAP, Apple faced two options: 1)restate its financials to recognize the MacBook revenue undersubscription accounting, or 2) charge users for the upgrade. Thecompany chose the latter option. Technology companies such as Applewere increasingly facing the issue of how to account for bundledcomponents as the software and hardware in these products becamemore integrated and integral to the products’ function. This placedU.S. technology companies on unequal footing with their overseascompetitors because International Financial Reporting Standards(IFRS) allowed companies to use a more subjective measure—cost plusmargin—when an objective and separate value could not beestablished for a future deliverable such as a free softwareupgrade. Consequently, an overseas company could report more than afraction of its revenue when it sold a bundled component with thepromise of a future deliverable such as a free upgrade. Companymanagement could estimate the cost and the margin of the upgradeand defer just that portion of the bundled component’s sale untilthe upgrade was delivered.Subscription Accounting The software andmagazine publishing industries were well known for their use ofsubscription accounting. Magazine publishers reported the cashreceived for a subscription at the time that the subscription waspurchased, but recorded the revenue only as each issue wasdelivered. The remaining balance was deferred into a liabilityaccount called unearned (or deferred) revenue. For example, if ayear’s subscription of a monthly magazine cost $12, then themagazine publisher would recognize $1 per month in revenue for 12months as the unearned revenue account decreased by $1 per month.Under subscription accounting, Apple recognized the associatedrevenue and cost of goods sold for the iPhone on a straight-linebasis over the product’s estimated 24-month economic life (thetypical length of a mobile phone service contract). When Appleannounced its quarterly results from iPhone sales, its reportedrevenues (and other related metrics) reflected only an eighth ofthe revenue from iPhone sales during that quarter. This resulted ina deferral of the remaining revenue and cost of sales relating toiPhones units sold, although the company received and reported thecash in the quarter of the sale. Each quarter, Apple also reporteda share of iPhone sales (both the revenue and the associated costof goods sold) for iPhones sold in previous quarters. (See Exhibit3 for an illustration of iPhone subscription accounting.) As longas the number of iPhone sales increased each quarter, the deferralbalance increased. Costs incurred for engineering, sales,marketing, and warranty were expensed as incurred. Reactions InJuly 2008, iPhone users validated Apple’s decision to offer freeupgrades when they quickly adopted the free iOS 2. Apple neverintended to give iPod touch users upgrades at no charge, and itsusers expressed confusion and dissatisfaction with their $9.95upgrade fee for the same software.15 At the same time, Apple’s useof subscription accounting drew mixed reviews from the businesscommunity. A Business Finance article praised Apple’s “smootherrevenue curve” that resulted from its use of subscriptionaccounting, saying, “Apple shows how a mature, astute organizationcan use revenue accounting rules to its benefit.”16 However, anApple 2.0 Fortune Tech post stated:More than seven months havepassed [since Apple’s use of subscription accounting began] andnobody—not the analysts, not the investors, and certainly not WallStreet—has quite wrapped their mind around what this bookkeepingoddity means for Apple's bottom line. That’s in part because it’scomplicated, and in part because Apple hasn’t provided all the datayou would need to fully assess its impact. But those so-calleddeferred earnings are adding up, and some professional Applewatchers are starting to realize that their impact could besubstantial .... And to the dismay of Apple shareholders, the factthat these deferred earnings are piling up seems to have gone rightover the heads of the institutional investors who have driven Appleshares down nearly 75 points since December.17 Non-GAAP SupplementsBy the fourth quarter of 2008, Apple’s management believed theimpact of subscription accounting on its financials was too big forthe company to ignore. Apple released select Q4 of FY 2008 non-GAAPfinancial results as supplements that gave Apple watchers theirfirst look at its revenue numbers without the use of subscriptionaccounting. Research suggested that companies issued non-GAAPsupplementary disclosures to communicate adjusted accountingnumbers that better predicted future performance, but also foropportunistic reasons.18 On average, investors appeared to weightnon-GAAP numbers more heavily compared to GAAP numbers when theyformed their expectations for future earnings, assuming they foundthe non-GAAP numbers informative and credible. Not surprisingly,research also showed that companies tended to emphasize measuresthat portrayed the most favorable performance.19 In 2003, theSecurities and Exchange Commission (SEC) issued new non-GAAPdisclosure rules to address concerns about the lack of oversight onthese disclosures. The SEC’s Regulation G required companies thatdisclosed non-GAAP financial measures to use the most comparableGAAP measures when preparing their non-GAAP disclosures, inaddition to providing a reconciliation of the GAAP and non-GAAPresults.20 Recent studies indicated that since the passage ofRegulation G, firms were less likely to provide non-GAAP earningsthat excluded expenses of a recurring nature.21 In describingApple’s non-GAAP financials, Jobs noted that iPhone non-GAAP saleswere a staggering $4.6 billion, 39% of Apple’s total revenue in thefourth quarter of 2008. See Table A. Q42008 GAAP Non-Gaap %increase Total Sales 7.9 11.7 48% Total Income 1.1 2.4 115% IphoneSales 0.8 4.6 475% Iphone as % of Sales 10% 39% Apple cautionedthat its non-GAAP calculations did not adjust for the estimatedcosts associated with its plan to provide new features and softwareupgrades to iPhone buyers free of charge. It also warned investorsthat these figures were not prepared under a comprehensive set ofrules or principles, since no standards existed for making thesecalculations. (See Exhibit 5 for Apple’s cautions on use of itsnon-GAAP supplements.) Apple also announced iPhone Q4 of FY 2008GAAP sales that just missed Wall Street’s estimates, but totalincome that easily beat analysts’ estimates.22 Apple’s guidance forthe first quarter of FY 2009 was well below Wall Street’s forecast.Apple’s stock closed down for the day. Conclusion The immediateanalyst reaction to Apple’s Q4 of FY 2008 financial results andconservative Q1 of FY 2009 guidance was largely positive, althoughMaynard Um of UBS downgraded his rating from “Buy” to “Neutral” andcut his share price target to $115 (from $125), citing “potentialmacro- economic issues impacting Mac sales.”23 In contrast, SheblySeyrafi of Calyon Securities raised his rating from “Add” to “Buy”and increased his price target to $150 (from $130), noting thatApple’s earnings per share (EPS) would have more than doubled hadit not been for the company’s use of subscription accounting foriPhone sales.24 Reaction to Apple’s decision to provide non-GAAPsupplements was more mixed. Proponents of Apple’s use of non-GAAPsupplements argued that these results were more consistent withApple’s $24.5 billion in cash and short-term investments. UnderGAAP, they pointed out, the iPhone’s strong shipments in Q4 of FY2008 were not fully reflected in Apple’s results. They alsocontended that valuations using non-GAAP measures were betterindicators of the company’s true financial performance.25ncontrast, GAAP proponents asserted that the Street penalizedtechnology companies reporting non-GAAP results. They argued thatApple’s management clearly believed future, free software upgradeswere critical to an iPhone buyer’s initial purchase decision andnecessitated Apple’s use of subscription accounting. Further, theyargued that non-GAAP supplements gave the iPhone too much weight,pointing to the fact that Apple’s quarterly numbers became moresensitive to iPhone unit sales, which were more volatile anddifficult for analysts to predict. Perhaps most importantly, theymaintained that investors knew to use cash revenue numbers forvaluations and ratios, and that changing to non-GAAP measuresshould have no impact on the economic value of Apple shares.26Apple announced that it would continue to provide non-GAAPsupplements during earnings releases. Only time would reveal theireffects, if any, on Apple’s share pricing. Questions 1. What wasApple Inc.’s business model for its iPhone in 2008? What was theirstrategy to make money and penetrate the market? 2. What issubscription accounting? How is it different from the standardrevenue recognition methods used to account for sale of electronicproducts? Why Apple used subscription accounting for its phones,and not for its other products? 3. How did the use of subscriptionaccounting affect key financial ratios of Apple Inc.? Which ratioswere likely to be most affected? 4. What were the reasons behindintroduction of Non-GAAP financial measures by Apple Inc. in 2008?What was the reaction of investment community? Note: Revision ofkey revenue recognition methods will be helpful for your analysis.Information on industry analysis from Chapter 2 might help youanswer question 1.

Answer & Explanation Solved by verified expert
4.3 Ratings (902 Votes)
1 What was Apple Incs business model for its iPhone in 2008 What was their strategy to make money and penetrate the market Although Apple took complete control over the developing and marketing of the iPhone by giving ATT the exclusivity period of five years in US markets Apples initial strategy for the iPhone was generally unsuccessful Apples decision to make the iPhone rely on a relatively slow Edge network 2G and 25G instead of the 3G network had a negative effect on the iPhones popularity In addition the iPhone was priced much too high to be competitive in the handset market because Apple didnt make ATT subsidize the iPhone Moreover Apples failure to expand the iPhone market to foreign countries fast enough by demanding a high share of service revenue resulted in many iPhones being sold in the worldwide gray market    See Answer
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In: AccountingAccounting for iPhone at Apple Inc On October 21, 2008, AppleInc. announced financial results for...Accounting for iPhone at Apple Inc On October 21, 2008, AppleInc. announced financial results for Q4 of FY 2008 ended September27, 2008 (see Exhibit 1). Under the U.S. generally acceptedaccounting principles (GAAP), Apple reported quarterly revenue of$7.9 billion and net profit of $1.1 billion. For the first time,the Cupertino, California-based company included non-GAAP measuresin its earnings announcement to supplement its U.S. GAAP financialresults. Apple’s non-GAAP quarterly revenue and net profit were$11.7 billion and $2.4 billion, respectively. As Apple CEO SteveJobs noted, “As you can see, the non-GAAP financial results aretruly stunning.”1 He explained the change in a rare appearance onthe company’s earnings conference call later that day: I would liketo . . . talk about the non-GAAP financial results, because I thinkthis is a pretty big deal. In addition to reporting an outstandingquarter, today we are also introducing non- GAAP financial results,which eliminate the impact of subscription accounting. Because byits nature subscription accounting spreads the impact of iPhone’scontribution to Apple’s overall sales, gross margin, and net incomeover two years, it can make it more difficult for the average Applemanager or the average investor to evaluate the company’s overallperformance. As long as our iPhone business was small relative toour Mac and music businesses, this didn’t really matter much, butthe past quarter, as you heard, our iPhone business has grown toabout $4.6 billion, or 39% of Apple’s total business, clearly toobig for Apple management or investors to ignore.2 Jobs also notedthat in terms of non-GAAP mobile-phone revenue, in just 15 monthsApple had become the world’s third-largest phone manufacturerbehind Nokia and Samsung but ahead of Sony Ericsson, LG, Motorola,and RIM. Company Background Jobs and Steve Wozniak launched thepersonal computer revolution in the 1970s with the Apple II. In1984, the Apple Macintosh, with its ease-of-use and brilliantdesign, redefined the personal computer. Shortly thereafter, Jobsleft the company, returning in 1997. Under Jobs, Apple catalyzedthe digital-media industry with the launch of its iPod portablemusical player in October 2001, followed by the introduction of itsiTunes online store in April 2003. In June 2007, the companyentered the highly competitive mobile-phone market with its iPhone,the first smartphone (a combination of a phone and a mini-computer)with a touch-screen interface and the company’s new mobileoperating system, iOS. Several months later, Apple released theiPod touch (an iPhone without the phone capability). Apple releasedits iPhone 3G in July 2008 along with its second-generation mobileoperating system (iOS 2). Also in July 2008, Apple introduced itsApp Store, which offered iPhone and iPod touch users a wide varietyof mobile applications ranging from games to social networking toproductivity tools, mostly priced under $10. On July 14, 2008, Jobsnoted, “The App Store is a grand slam, with a staggering 10 millionapplications downloaded in just three days. Developers have createdsome extraordinary applications, and the App Store can wirelesslydeliver them to every iPhone and iPod touch user instantly.”3 Manyof the applications took advantage of the more robust iOS 2. ByOctober 2008, Apple was best known for its technical and designinnovation, its “walled garden” approach (i.e., its mostlyproprietary ecosystem of hardware, operating and applicationsoftware, and peripherals), and its premium-priced products. iPhoneBusiness Model The original iPhone 8GB model had a U.S. retailprice of $399 and was available through Apple and AT&T, theiPhone’s exclusive U.S. mobile carrier. In the U.S., mobilecarriers typically provided subsidies to phone manufacturers, whichlowered the purchase price of the new phone. In exchange, mostconsumers signed a two-year service contract with the carriers.Apple and AT&T agreed to a different arrangement, but did notdisclose its specifics. AT&T did not subsidize the iPhone;instead, Apple signed a revenue-sharing agreement with AT&Tthat gave Apple a share of the subscribers’ monthly service fees.Needham & Co. analyst Charles Wolf believed that AT&T paidApple $10 per month over a typical two-year contract.4 In addition,although Apple did not disclose how much it sold the iPhone for toAT&T, analysts believed that Apple made an estimated $120 ingross profit on every iPhone sold.5 At the iPhone’s launch, Appleannounced it might periodically offer new software updates andupgrades free of charge to its iPhone customers. In contrast, Macand iPod users did not receive free software features and upgrades.For example, users were charged $129 to upgrade to the new Macoperating system (Mac OS X Leopard) in October 2007, whereas Appleplanned to provide newer versions of the iPhone operating systemfree of charge to all iPhone users. Apple’s chief financial officerPeter Oppenheimer explained, “Since iPhone customers will likely beour best advocates for the product, we want to get them many ofthese new features and applications at no additional charge as theybecome available.”6 In addition, Apple’s management knew thatsmartphone users were slow to update their software, and that fewopted to buy upgrades. Therefore, the company believed it wasnecessary to offer new software features free of charge to increaseuser acceptance. In contrast, most other mobile software vendorsreserved new software updates for new hardware (i.e., phone)releases.7 Apple, AT&T, third-party application developers, andusers would all benefit from consumers’ use of the latest operatingsystem and applications, giving Apple and its ecosystem acompetitive advantage. AT&T would run a more effective andefficient mobile network; third-party software developers wouldhave a stable hardware and software roadmap; Apple could delistapplications from its App Store that weren’t written for its latestoperating system; and all the while, iPhone users would benefitfrom an evolving and differentiated set of features andfunctionality. Many users ofcompeting mobile-phone platforms couldnot upgrade to newer operating systems and applications because ofcompatibility issues with their phones. When Apple launched theiPhone 3G in July 2008, it revamped its business model, bringing itmore in line with industry practices. Apple gave up its share ofthe monthly service revenue in exchange for AT&T subsidizingthe price of the iPhone 3G, which sold for $199 at retail. Again,the two parties chose not to disclose the specifics of theirarrangement, but the subsidy was estimated at $300 per phone sold.8Apple continued to differ from most other industry participantswhen it offered existing iPhone users upgrades to itssecond-generation operating system at no cost. By August 2008, amonth after Apple introduced its App Store, Jobs noted that usersdownloaded more than 60 million programs for the iPhone, and Applewas averaging $1 million a day in application-software revenue.Apple received 30% of the App Store revenue from the sale of aniPhone application, and the developer received the remaining 70%.9Jobs stated, “Phone differentiation used to be about radios andantennas and things like that. We think, going forward, the phoneof the future will be differentiated by software.”10 Also in August2008, the New York Times reported that T-Mobile would be the firstcarrier to launch mobile phones using Google’s Android mobileoperating system; the phones were expected to hit shelves in lateOctober 2008. On October 21, 2008, Google announced that Androidwas now “the first free, open source, and fully customizable mobileplatform.” iPhone Revenue Recognition Software-enabled hardwaredevices (also known as “bundled components”), such as Apple’siPhone, Macs, and iPods, fell under the software revenuerecognition rules pursuant to American Institute of CertifiedPublic Accountants (AICPA) Statement of Position (SOP) No. 97-2,Software Revenue Recognition. When Apple first introduced theiPhone in 2007, the company announced it would use the“subscription method of accounting” under SOP No. 97-2 to bookrevenue for its new iPhone. Oppenheimer explained: Since we will beperiodically providing new software features to iPhone customersfree of charge, we will use subscription accounting and recognizethe revenue and product cost of goods sold associated with iPhonehandset sales on a straight line basis over 24 months. So while thecash from iPhone sales will be collected at the time of sale, wewill be recording deferred revenue and costs of goods sold on ourbalance sheet, and amortizing both of them into our earnings on astraight line basis over 24 months. We will continue to expense ouriPhone engineering, sales, and marketing costs as we incur them.This accounting policy will have no impact on cash flow or theeconomics of our business.12 In contrast, Apple generallyrecognized revenue and cost of sales for its other software-enabledhardware products such as Macs and iPods at the time of sale (i.e.,immediate revenue recognition) under SOP No. 97-2. This was becausethe company did not provide new features or software applicationsfor those products free of charge. (See Exhibit 2 for the FY 2008financial statement note relating to Apple’s revenue recognitionpolicies under GAAP.) Apple’s decision to use subscriptionaccounting for the iPhone came soon after the company facedconsumer backlash over a $5 upgrade fee (later reduced to $1.99) itcharged new MacBook buyers.13 In 2006, Apple sold its latestMacBook with a wireless chip that would allow users to access thenew and better Wi-Fi 802.11n technology once it became availableand the chip was activated withsoftware. Apple did not tell MacBookbuyers about the chip’s existence, and it also recognized allrevenue at the time the MacBooks sold. Thus, the chip and itsactivation software were an unspecified, future upgrade that didnot have an established, objective, separate value (which wouldhave allowed it to be accounted for separately) at the time of theMacBook sale. To comply with GAAP, Apple faced two options: 1)restate its financials to recognize the MacBook revenue undersubscription accounting, or 2) charge users for the upgrade. Thecompany chose the latter option. Technology companies such as Applewere increasingly facing the issue of how to account for bundledcomponents as the software and hardware in these products becamemore integrated and integral to the products’ function. This placedU.S. technology companies on unequal footing with their overseascompetitors because International Financial Reporting Standards(IFRS) allowed companies to use a more subjective measure—cost plusmargin—when an objective and separate value could not beestablished for a future deliverable such as a free softwareupgrade. Consequently, an overseas company could report more than afraction of its revenue when it sold a bundled component with thepromise of a future deliverable such as a free upgrade. Companymanagement could estimate the cost and the margin of the upgradeand defer just that portion of the bundled component’s sale untilthe upgrade was delivered.Subscription Accounting The software andmagazine publishing industries were well known for their use ofsubscription accounting. Magazine publishers reported the cashreceived for a subscription at the time that the subscription waspurchased, but recorded the revenue only as each issue wasdelivered. The remaining balance was deferred into a liabilityaccount called unearned (or deferred) revenue. For example, if ayear’s subscription of a monthly magazine cost $12, then themagazine publisher would recognize $1 per month in revenue for 12months as the unearned revenue account decreased by $1 per month.Under subscription accounting, Apple recognized the associatedrevenue and cost of goods sold for the iPhone on a straight-linebasis over the product’s estimated 24-month economic life (thetypical length of a mobile phone service contract). When Appleannounced its quarterly results from iPhone sales, its reportedrevenues (and other related metrics) reflected only an eighth ofthe revenue from iPhone sales during that quarter. This resulted ina deferral of the remaining revenue and cost of sales relating toiPhones units sold, although the company received and reported thecash in the quarter of the sale. Each quarter, Apple also reporteda share of iPhone sales (both the revenue and the associated costof goods sold) for iPhones sold in previous quarters. (See Exhibit3 for an illustration of iPhone subscription accounting.) As longas the number of iPhone sales increased each quarter, the deferralbalance increased. Costs incurred for engineering, sales,marketing, and warranty were expensed as incurred. Reactions InJuly 2008, iPhone users validated Apple’s decision to offer freeupgrades when they quickly adopted the free iOS 2. Apple neverintended to give iPod touch users upgrades at no charge, and itsusers expressed confusion and dissatisfaction with their $9.95upgrade fee for the same software.15 At the same time, Apple’s useof subscription accounting drew mixed reviews from the businesscommunity. A Business Finance article praised Apple’s “smootherrevenue curve” that resulted from its use of subscriptionaccounting, saying, “Apple shows how a mature, astute organizationcan use revenue accounting rules to its benefit.”16 However, anApple 2.0 Fortune Tech post stated:More than seven months havepassed [since Apple’s use of subscription accounting began] andnobody—not the analysts, not the investors, and certainly not WallStreet—has quite wrapped their mind around what this bookkeepingoddity means for Apple's bottom line. That’s in part because it’scomplicated, and in part because Apple hasn’t provided all the datayou would need to fully assess its impact. But those so-calleddeferred earnings are adding up, and some professional Applewatchers are starting to realize that their impact could besubstantial .... And to the dismay of Apple shareholders, the factthat these deferred earnings are piling up seems to have gone rightover the heads of the institutional investors who have driven Appleshares down nearly 75 points since December.17 Non-GAAP SupplementsBy the fourth quarter of 2008, Apple’s management believed theimpact of subscription accounting on its financials was too big forthe company to ignore. Apple released select Q4 of FY 2008 non-GAAPfinancial results as supplements that gave Apple watchers theirfirst look at its revenue numbers without the use of subscriptionaccounting. Research suggested that companies issued non-GAAPsupplementary disclosures to communicate adjusted accountingnumbers that better predicted future performance, but also foropportunistic reasons.18 On average, investors appeared to weightnon-GAAP numbers more heavily compared to GAAP numbers when theyformed their expectations for future earnings, assuming they foundthe non-GAAP numbers informative and credible. Not surprisingly,research also showed that companies tended to emphasize measuresthat portrayed the most favorable performance.19 In 2003, theSecurities and Exchange Commission (SEC) issued new non-GAAPdisclosure rules to address concerns about the lack of oversight onthese disclosures. The SEC’s Regulation G required companies thatdisclosed non-GAAP financial measures to use the most comparableGAAP measures when preparing their non-GAAP disclosures, inaddition to providing a reconciliation of the GAAP and non-GAAPresults.20 Recent studies indicated that since the passage ofRegulation G, firms were less likely to provide non-GAAP earningsthat excluded expenses of a recurring nature.21 In describingApple’s non-GAAP financials, Jobs noted that iPhone non-GAAP saleswere a staggering $4.6 billion, 39% of Apple’s total revenue in thefourth quarter of 2008. See Table A. Q42008 GAAP Non-Gaap %increase Total Sales 7.9 11.7 48% Total Income 1.1 2.4 115% IphoneSales 0.8 4.6 475% Iphone as % of Sales 10% 39% Apple cautionedthat its non-GAAP calculations did not adjust for the estimatedcosts associated with its plan to provide new features and softwareupgrades to iPhone buyers free of charge. It also warned investorsthat these figures were not prepared under a comprehensive set ofrules or principles, since no standards existed for making thesecalculations. (See Exhibit 5 for Apple’s cautions on use of itsnon-GAAP supplements.) Apple also announced iPhone Q4 of FY 2008GAAP sales that just missed Wall Street’s estimates, but totalincome that easily beat analysts’ estimates.22 Apple’s guidance forthe first quarter of FY 2009 was well below Wall Street’s forecast.Apple’s stock closed down for the day. Conclusion The immediateanalyst reaction to Apple’s Q4 of FY 2008 financial results andconservative Q1 of FY 2009 guidance was largely positive, althoughMaynard Um of UBS downgraded his rating from “Buy” to “Neutral” andcut his share price target to $115 (from $125), citing “potentialmacro- economic issues impacting Mac sales.”23 In contrast, SheblySeyrafi of Calyon Securities raised his rating from “Add” to “Buy”and increased his price target to $150 (from $130), noting thatApple’s earnings per share (EPS) would have more than doubled hadit not been for the company’s use of subscription accounting foriPhone sales.24 Reaction to Apple’s decision to provide non-GAAPsupplements was more mixed. Proponents of Apple’s use of non-GAAPsupplements argued that these results were more consistent withApple’s $24.5 billion in cash and short-term investments. UnderGAAP, they pointed out, the iPhone’s strong shipments in Q4 of FY2008 were not fully reflected in Apple’s results. They alsocontended that valuations using non-GAAP measures were betterindicators of the company’s true financial performance.25ncontrast, GAAP proponents asserted that the Street penalizedtechnology companies reporting non-GAAP results. They argued thatApple’s management clearly believed future, free software upgradeswere critical to an iPhone buyer’s initial purchase decision andnecessitated Apple’s use of subscription accounting. Further, theyargued that non-GAAP supplements gave the iPhone too much weight,pointing to the fact that Apple’s quarterly numbers became moresensitive to iPhone unit sales, which were more volatile anddifficult for analysts to predict. Perhaps most importantly, theymaintained that investors knew to use cash revenue numbers forvaluations and ratios, and that changing to non-GAAP measuresshould have no impact on the economic value of Apple shares.26Apple announced that it would continue to provide non-GAAPsupplements during earnings releases. Only time would reveal theireffects, if any, on Apple’s share pricing. Questions 1. What wasApple Inc.’s business model for its iPhone in 2008? What was theirstrategy to make money and penetrate the market? 2. What issubscription accounting? How is it different from the standardrevenue recognition methods used to account for sale of electronicproducts? Why Apple used subscription accounting for its phones,and not for its other products? 3. How did the use of subscriptionaccounting affect key financial ratios of Apple Inc.? Which ratioswere likely to be most affected? 4. What were the reasons behindintroduction of Non-GAAP financial measures by Apple Inc. in 2008?What was the reaction of investment community? Note: Revision ofkey revenue recognition methods will be helpful for your analysis.Information on industry analysis from Chapter 2 might help youanswer question 1.

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