Accounting for iPhone at Apple Inc

On October 21, 2008, Apple Inc. announced financial results forQ4 of FY 2008 ended September 27, 2008 (see Exhibit 1). Under theU.S. generally accepted accounting principles (GAAP), Applereported quarterly revenue of $7.9 billion and net profit of $1.1billion. For the first time, the Cupertino, California-basedcompany included non-GAAP measures in its earnings announcement tosupplement its U.S. GAAP financial results. Apple’s non-GAAPquarterly revenue and net profit were $11.7 billion and $2.4billion, respectively. As Apple CEO Steve Jobs noted, “As you cansee, the non-GAAP financial results are truly stunning.”1 Heexplained the change in a rare appearance on the company’s earningsconference call later that day: I would like to . . . talk aboutthe non-GAAP financial results, because I think this is a prettybig deal. In addition to reporting an outstanding quarter, today weare also introducing non- GAAP financial results, which eliminatethe impact of subscription accounting. Because by its naturesubscription accounting spreads the impact of iPhone’s contributionto Apple’s overall sales, gross margin, and net income over twoyears, it can make it more difficult for the average Apple manageror 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 the personal computer revolutionin the 1970s with the Apple II. In 1984, the Apple Macintosh, withits ease-of-use and brilliant design, redefined the personalcomputer. Shortly thereafter, Jobs left the company, returning in1997. Under Jobs, Apple catalyzed the digital-media industry withthe launch of its iPod portable musical player in October 2001,followed by the introduction of its iTunes online store in April2003. In June 2007, the company entered the highly competitivemobile-phone market with its iPhone, the first smartphone (acombination of a phone and a mini-computer) with a touch-screeninterface and the company’s new mobile operating system, iOS.Several months later, Apple released the iPod touch (an iPhonewithout the phone capability). Apple released its iPhone 3G in July2008 along with its second-generation mobile operating system (iOS2). Also in July 2008, Apple introduced its App Store, whichoffered iPhone and iPod touch users a wide variety of mobileapplications 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. i

Phone Business Model

The original iPhone 8GB model had a U.S. retail price of $399and was available through Apple and AT&T, the iPhone’sexclusive U.S. mobile carrier. In the U.S., mobile carrierstypically provided subsidies to phone manufacturers, which loweredthe purchase price of the new phone. In exchange, most consumerssigned a two-year service contract with the carriers. Apple andAT&T agreed to a different arrangement, but did not discloseits specifics. AT&T did not subsidize the iPhone; instead,Apple signed a revenue-sharing agreement with AT&T that gaveApple a share of the subscribers’ monthly service fees. Needham& Co. analyst Charles Wolf believed that AT&T paid Apple$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 hardware devices (also known as “bundledcomponents”), such as Apple’s iPhone, Macs, and iPods, fell underthe software revenue recognition rules pursuant to AmericanInstitute of Certified Public Accountants (AICPA) Statement ofPosition (SOP) No. 97-2, Software Revenue Recognition. When Applefirst introduced the iPhone in 2007, the company announced it woulduse the “subscription method of accounting” under SOP No. 97-2 tobook revenue for its new iPhone. Oppenheimer explained: Since wewill be periodically providing new software features to iPhonecustomers free of charge, we will use subscription accounting andrecognize the revenue and product cost of goods sold associatedwith iPhone handset sales on a straight line basis over 24 months.So while the cash from iPhone sales will be collected at the timeof sale, we will be recording deferred revenue and costs of goodssold on our balance sheet, and amortizing both of them into ourearnings on a straight line basis over 24 months. We will continueto expense our iPhone engineering, sales, and marketing costs as weincur them. This accounting policy will have no impact on cash flowor the economics 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 Supplements

By 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 immediate analyst reaction to Apple’s Q4 of FY 2008financial results and conservative Q1 of FY 2009 guidance waslargely positive, although Maynard Um of UBS downgraded his ratingfrom “Buy” to “Neutral” and cut his share price target to $115(from $125), citing “potential macro- economic issues impacting Macsales.”23 In contrast, Shebly Seyrafi of Calyon Securities raisedhis rating from “Add” to “Buy” and increased his price target to$150 (from $130), noting that Apple’s earnings per share (EPS)would have more than doubled had it not been for the company’s useof subscription accounting for iPhone sales.24 Reaction to Apple’sdecision to provide non-GAAP supplements was more mixed. Proponentsof Apple’s use of non-GAAP supplements argued that these resultswere more consistent with Apple’s $24.5 billion in cash andshort-term investments. Under GAAP, they pointed out, the iPhone’sstrong shipments in Q4 of FY 2008 were not fully reflected inApple’s results. They also contended that valuations using non-GAAPmeasures were better indicators of the company’s true financialperformance.25n contrast, GAAP proponents asserted that the Streetpenalized technology companies reporting non-GAAP results. Theyargued that Apple’s management clearly believed future, freesoftware upgrades were critical to an iPhone buyer’s initialpurchase decision and necessitated Apple’s use of subscriptionaccounting. Further, they argued that non-GAAP supplements gave theiPhone too much weight, pointing to the fact that Apple’s quarterlynumbers became more sensitive to iPhone unit sales, which were morevolatile and difficult for analysts to predict. Perhaps mostimportantly, they maintained that investors knew to use cashrevenue numbers for valuations and ratios, and that changing tonon-GAAP measures should have no impact on the economic value ofApple shares.26 Apple announced that it would continue to providenon-GAAP supplements during earnings releases. Only time wouldreveal their effects, if any, on Apple’s share pricing.

Questions

1. What was Apple Inc.’s business model for its iPhone in 2008?What was their strategy to make money and penetrate the market?

2. What is subscription accounting? How is it different from thestandard revenue recognition methods used to account for sale ofelectronic products? Why Apple used subscription accounting for itsphones, and not for its other products?

3. How did the use of subscription accounting affect keyfinancial ratios of Apple Inc.? Which ratios were likely to be mostaffected?

4. What were the reasons behind introduction of Non-GAAPfinancial measures by Apple Inc. in 2008? What was the reaction ofinvestment community?

Note: Revision of key revenue recognition methods will behelpful for your analysis. Information on industry analysis fromChapter 2 might help you answer question 1.