Question

Accounting for iPhone at Apple Inc On October 21, 2008, Apple Inc. announced financial results for Q4 of FY 2008 ended September 27, 2008 (see Exhibit 1). Under the U.S. generally accepted accounting 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 measures in its earnings announcement to supplement its U.S. GAAP financial results. Apple’s non-GAAP quarterly revenue and net profit were $11.7 billion and $2.4 billion, respectively. As Apple CEO Steve Jobs noted, “As you can see, the non-GAAP financial results are truly stunning.”1 He explained the change in a rare appearance on the company’s earnings conference call later that day: I would like to . . . talk about the non-GAAP financial results, because I think this is a pretty big deal. In addition to reporting an outstanding quarter, today we are also introducing non- GAAP financial results, which eliminate the impact of subscription accounting. Because by its nature subscription accounting spreads the impact of iPhone’s contribution to Apple’s overall sales, gross margin, and net income over two years, it can make it more difficult for the average Apple manager or the average investor to evaluate the company’s overall performance. As long as our iPhone business was small relative to our Mac and music businesses, this didn’t really matter much, but the past quarter, as you heard, our iPhone business has grown to about $4.6 billion, or 39% of Apple’s total business, clearly too big for Apple management or investors to ignore.2 Jobs also noted that in terms of non-GAAP mobile-phone revenue, in just 15 months Apple had become the world’s third-largest phone manufacturer behind Nokia and Samsung but ahead of Sony Ericsson, LG, Motorola, and RIM. Company Background Jobs and Steve Wozniak launched the personal computer revolution in the 1970s with the Apple II. In 1984, the Apple Macintosh, with its ease-of-use and brilliant design, redefined the personal computer. Shortly thereafter, Jobs left the company, returning in 1997. Under Jobs, Apple catalyzed the digital-media industry with the launch of its iPod portable musical player in October 2001, followed by the introduction of its iTunes online store in April 2003. In June 2007, the company entered 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 mobile operating system, iOS. Several months later, Apple released the iPod touch (an iPhone without the phone capability). Apple released its iPhone 3G in July 2008 along with its second-generation mobile operating system (iOS 2). Also in July 2008, Apple introduced its App Store, which offered iPhone and iPod touch users a wide variety of mobile applications ranging from games to social networking to productivity tools, mostly priced under $10. On July 14, 2008, Jobs noted, “The App Store is a grand slam, with a staggering 10 million applications downloaded in just three days. Developers have created some extraordinary applications, and the App Store can wirelessly deliver them to every iPhone and iPod touch user instantly.”3 Many of the applications took advantage of the more robust iOS 2. By October 2008, Apple was best known for its technical and design innovation, its “walled garden” approach (i.e., its mostly proprietary ecosystem of hardware, operating and application software, and peripherals), and its premium-priced products. iPhone Business Model The original iPhone 8GB model had a U.S. retail price of $399 and was available through Apple and AT&T, the iPhone’s exclusive U.S. mobile carrier. In the U.S., mobile carriers typically provided subsidies to phone manufacturers, which lowered the purchase price of the new phone. In exchange, most consumers signed a two-year service contract with the carriers. Apple and AT&T agreed to a different arrangement, but did not disclose its specifics. AT&T did not subsidize the iPhone; instead, Apple signed a revenue-sharing agreement with AT&T that gave Apple 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 to AT&T, analysts believed that Apple made an estimated $120 in gross profit on every iPhone sold.5 At the iPhone’s launch, Apple announced it might periodically offer new software updates and upgrades free of charge to its iPhone customers. In contrast, Mac and iPod users did not receive free software features and upgrades. For example, users were charged $129 to upgrade to the new Mac operating system (Mac OS X Leopard) in October 2007, whereas Apple planned to provide newer versions of the iPhone operating system free of charge to all iPhone users. Apple’s chief financial officer Peter Oppenheimer explained, “Since iPhone customers will likely be our best advocates for the product, we want to get them many of these new features and applications at no additional charge as they become available.”6 In addition, Apple’s management knew that smartphone users were slow to update their software, and that few opted to buy upgrades. Therefore, the company believed it was necessary to offer new software features free of charge to increase user acceptance. In contrast, most other mobile software vendors reserved new software updates for new hardware (i.e., phone) releases.7 Apple, AT&T, third-party application developers, and users would all benefit from consumers’ use of the latest operating system and applications, giving Apple and its ecosystem a competitive advantage. AT&T would run a more effective and efficient mobile network; third-party software developers would have a stable hardware and software roadmap; Apple could delist applications from its App Store that weren’t written for its latest operating system; and all the while, iPhone users would benefit from an evolving and differentiated set of features and functionality. Many users ofcompeting mobile-phone platforms could not upgrade to newer operating systems and applications because of compatibility issues with their phones. When Apple launched the iPhone 3G in July 2008, it revamped its business model, bringing it more in line with industry practices. Apple gave up its share of the monthly service revenue in exchange for AT&T subsidizing the price of the iPhone 3G, which sold for $199 at retail. Again, the two parties chose not to disclose the specifics of their arrangement, but the subsidy was estimated at $300 per phone sold.8 Apple continued to differ from most other industry participants when it offered existing iPhone users upgrades to its second-generation operating system at no cost. By August 2008, a month after Apple introduced its App Store, Jobs noted that users downloaded more than 60 million programs for the iPhone, and Apple was averaging $1 million a day in application-software revenue. Apple received 30% of the App Store revenue from the sale of an iPhone application, and the developer received the remaining 70%.9 Jobs stated, “Phone differentiation used to be about radios and antennas and things like that. We think, going forward, the phone of the future will be differentiated by software.”10 Also in August 2008, the New York Times reported that T-Mobile would be the first carrier to launch mobile phones using Google’s Android mobile operating system; the phones were expected to hit shelves in late October 2008. On October 21, 2008, Google announced that Android was now “the first free, open source, and fully customizable mobile platform.” iPhone Revenue Recognition Software-enabled hardware devices (also known as “bundled components”), such as Apple’s iPhone, Macs, and iPods, fell under the software revenue recognition rules pursuant to American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) No. 97-2, Software Revenue Recognition. When Apple first introduced the iPhone in 2007, the company announced it would use the “subscription method of accounting” under SOP No. 97-2 to book revenue for its new iPhone. Oppenheimer explained: Since we will be periodically providing new software features to iPhone customers free of charge, we will use subscription accounting and recognize the revenue and product cost of goods sold associated with iPhone handset sales on a straight line basis over 24 months. So while the cash from iPhone sales will be collected at the time of sale, we will be recording deferred revenue and costs of goods sold on our balance sheet, and amortizing both of them into our earnings on a straight line basis over 24 months. We will continue to expense our iPhone engineering, sales, and marketing costs as we incur them. This accounting policy will have no impact on cash flow or the economics of our business.12 In contrast, Apple generally recognized revenue and cost of sales for its other software-enabled hardware products such as Macs and iPods at the time of sale (i.e., immediate revenue recognition) under SOP No. 97-2. This was because the company did not provide new features or software applications for those products free of charge. (See Exhibit 2 for the FY 2008 financial statement note relating to Apple’s revenue recognition policies under GAAP.) Apple’s decision to use subscription accounting for the iPhone came soon after the company faced consumer backlash over a $5 upgrade fee (later reduced to $1.99) it charged new MacBook buyers.13 In 2006, Apple sold its latest MacBook with a wireless chip that would allow users to access the new and better Wi-Fi 802.11n technology once it became available and the chip was activated withsoftware. Apple did not tell MacBook buyers about the chip’s existence, and it also recognized all revenue at the time the MacBooks sold. Thus, the chip and its activation software were an unspecified, future upgrade that did not have an established, objective, separate value (which would have allowed it to be accounted for separately) at the time of the MacBook sale. To comply with GAAP, Apple faced two options: 1) restate its financials to recognize the MacBook revenue under subscription accounting, or 2) charge users for the upgrade. The company chose the latter option. Technology companies such as Apple were increasingly facing the issue of how to account for bundled components as the software and hardware in these products became more integrated and integral to the products’ function. This placed U.S. technology companies on unequal footing with their overseas competitors because International Financial Reporting Standards (IFRS) allowed companies to use a more subjective measure—cost plus margin—when an objective and separate value could not be established for a future deliverable such as a free software upgrade. Consequently, an overseas company could report more than a fraction of its revenue when it sold a bundled component with the promise of a future deliverable such as a free upgrade. Company management could estimate the cost and the margin of the upgrade and defer just that portion of the bundled component’s sale until the upgrade was delivered.Subscription Accounting The software and magazine publishing industries were well known for their use of subscription accounting. Magazine publishers reported the cash received for a subscription at the time that the subscription was purchased, but recorded the revenue only as each issue was delivered. The remaining balance was deferred into a liability account called unearned (or deferred) revenue. For example, if a year’s subscription of a monthly magazine cost $12, then the magazine publisher would recognize $1 per month in revenue for 12 months as the unearned revenue account decreased by $1 per month. Under subscription accounting, Apple recognized the associated revenue and cost of goods sold for the iPhone on a straight-line basis over the product’s estimated 24-month economic life (the typical length of a mobile phone service contract). When Apple announced its quarterly results from iPhone sales, its reported revenues (and other related metrics) reflected only an eighth of the revenue from iPhone sales during that quarter. This resulted in a deferral of the remaining revenue and cost of sales relating to iPhones units sold, although the company received and reported the cash in the quarter of the sale. Each quarter, Apple also reported a share of iPhone sales (both the revenue and the associated cost of goods sold) for iPhones sold in previous quarters. (See Exhibit 3 for an illustration of iPhone subscription accounting.) As long as the number of iPhone sales increased each quarter, the deferral balance increased. Costs incurred for engineering, sales, marketing, and warranty were expensed as incurred. Reactions In July 2008, iPhone users validated Apple’s decision to offer free upgrades when they quickly adopted the free iOS 2. Apple never intended to give iPod touch users upgrades at no charge, and its users expressed confusion and dissatisfaction with their $9.95 upgrade fee for the same software.15 At the same time, Apple’s use of subscription accounting drew mixed reviews from the business community. A Business Finance article praised Apple’s “smoother revenue curve” that resulted from its use of subscription accounting, saying, “Apple shows how a mature, astute organization can use revenue accounting rules to its benefit.”16 However, an Apple 2.0 Fortune Tech post stated:More than seven months have passed [since Apple’s use of subscription accounting began] and nobody—not the analysts, not the investors, and certainly not Wall Street—has quite wrapped their mind around what this bookkeeping oddity means for Apple's bottom line. That’s in part because it’s complicated, and in part because Apple hasn’t provided all the data you would need to fully assess its impact. But those so-called deferred earnings are adding up, and some professional Apple watchers are starting to realize that their impact could be substantial .... And to the dismay of Apple shareholders, the fact that these deferred earnings are piling up seems to have gone right over the heads of the institutional investors who have driven Apple shares down nearly 75 points since December.17 Non-GAAP Supplements By the fourth quarter of 2008, Apple’s management believed the impact of subscription accounting on its financials was too big for the company to ignore. Apple released select Q4 of FY 2008 non-GAAP financial results as supplements that gave Apple watchers their first look at its revenue numbers without the use of subscription accounting. Research suggested that companies issued non-GAAP supplementary disclosures to communicate adjusted accounting numbers that better predicted future performance, but also for opportunistic reasons.18 On average, investors appeared to weight non-GAAP numbers more heavily compared to GAAP numbers when they formed their expectations for future earnings, assuming they found the non-GAAP numbers informative and credible. Not surprisingly, research also showed that companies tended to emphasize measures that portrayed the most favorable performance.19 In 2003, the Securities and Exchange Commission (SEC) issued new non-GAAP disclosure rules to address concerns about the lack of oversight on these disclosures. The SEC’s Regulation G required companies that disclosed non-GAAP financial measures to use the most comparable GAAP measures when preparing their non-GAAP disclosures, in addition to providing a reconciliation of the GAAP and non-GAAP results.20 Recent studies indicated that since the passage of Regulation G, firms were less likely to provide non-GAAP earnings that excluded expenses of a recurring nature.21 In describing Apple’s non-GAAP financials, Jobs noted that iPhone non-GAAP sales were a staggering $4.6 billion, 39% of Apple’s total revenue in the fourth 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% Iphone Sales 0.8 4.6 475% Iphone as % of Sales 10% 39% Apple cautioned that its non-GAAP calculations did not adjust for the estimated costs associated with its plan to provide new features and software upgrades to iPhone buyers free of charge. It also warned investors that these figures were not prepared under a comprehensive set of rules or principles, since no standards existed for making these calculations. (See Exhibit 5 for Apple’s cautions on use of its non-GAAP supplements.) Apple also announced iPhone Q4 of FY 2008 GAAP sales that just missed Wall Street’s estimates, but total income that easily beat analysts’ estimates.22 Apple’s guidance for the 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 2008 financial results and conservative Q1 of FY 2009 guidance was largely positive, although Maynard Um of UBS downgraded his rating from “Buy” to “Neutral” and cut his share price target to $115 (from $125), citing “potential macro- economic issues impacting Mac sales.”23 In contrast, Shebly Seyrafi of Calyon Securities raised his 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 use of subscription accounting for iPhone sales.24 Reaction to Apple’s decision to provide non-GAAP supplements was more mixed. Proponents of Apple’s use of non-GAAP supplements argued that these results were more consistent with Apple’s $24.5 billion in cash and short-term investments. Under GAAP, they pointed out, the iPhone’s strong shipments in Q4 of FY 2008 were not fully reflected in Apple’s results. They also contended that valuations using non-GAAP measures were better indicators of the company’s true financial performance.25n contrast, GAAP proponents asserted that the Street penalized technology companies reporting non-GAAP results. They argued that Apple’s management clearly believed future, free software upgrades were critical to an iPhone buyer’s initial purchase decision and necessitated Apple’s use of subscription accounting. Further, they argued that non-GAAP supplements gave the iPhone too much weight, pointing to the fact that Apple’s quarterly numbers became more sensitive to iPhone unit sales, which were more volatile and difficult for analysts to predict. Perhaps most importantly, they maintained that investors knew to use cash revenue numbers for valuations and ratios, and that changing to non-GAAP measures should have no impact on the economic value of Apple shares.26 Apple announced that it would continue to provide non-GAAP supplements during earnings releases. Only time would reveal 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 the standard revenue recognition methods used to account for sale of electronic products? Why Apple used subscription accounting for its phones, and not for its other products? 3. How did the use of subscription accounting affect key financial ratios of Apple Inc.? Which ratios were likely to be most affected? 4. What were the reasons behind introduction of Non-GAAP financial measures by Apple Inc. in 2008? What was the reaction of investment community? Note: Revision of key revenue recognition methods will be helpful for your analysis. Information on industry analysis from Chapter 2 might help you answer question 1.

Answer 1

1. What was Apple Inc.’s 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 AT&T the exclusivity period of five years in US markets, Apple's initial strategy for the iPhone was generally unsuccessful. Apple's decision to make the iPhone rely on a relatively slow Edge network (2G and 2.5G) instead of the 3G network had a negative effect on the iPhone's popularity. In addition, the iPhone was priced much too high to be competitive in the handset market because Apple didn't make AT&T subsidize the iPhone. Moreover, Apple's 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" at a loss of service -share revenue of $1 billion over a three -year period.

Apple changed very quickly to different strategies because the iPhone simply wasn't selling as well as they had expected. First of all, Apple had to develop the iPhone to run on 3G networks, since iPhones were too slow compared to other 3G products. Next, Apple had to lower the price of the iPhone by subsidizing from AT &T and by giving up its share of iPhone subscription revenue because the handsets that cost more than $300 accounted for only 5% of the market. Apple also expanded the iPhone retail channel to include huge chains like Best Buy and Walmart to boost its sales. Apple then launched the iPhone 3G in the worldwide market by giving up the share of service revenue to avoid iPhone leakage into the gray market. Finally, Apple came up with a platform of third -party applications for the iPhone, finding a new source of revenue from the Application Store

Why Apple used subscription accounting for its phones, and not for its other products?

Apple does so because it is compelled to, thanks to the Financial Accounting Standards Board.It is known that iPhone has on Apple's numbers. Apple points this out on its conference call when it highlights the spread between its GAAP, generally accepted accounting principles, and its non-GAAP results.And those GAAP rules mask iPhone's true and enormous impact.

What is the difference?

Apple defers related iPhone revenue over the 24-month term of the typical iPhone contract, necessary because Apple offers free software updates through the phone's useful life.. Therefore, Apple must use subscription accounting.

3. How did the use of subscription accounting affect key financial ratios of Apple Inc.? Which ratios were likely to be most affected?

Apple proposed to recognize all revenues and COGS from sales of iPhones in the Qtr.There are shipped /delivered by the transfer of property and risk is transferred instead of using the subscription accounting method demanded by USGAAP,which deferred the recognition of revenue and COGS upto 2 yrs straight line .Under Apple’s proposed method equity position shown at the Balance Sheet would be much higher ie lower liability –deferred revenue and higher retained earnings..Higher recognized revenues,COGS would drive Net Income higher at the Income Statement .Leverage ratios such as Debt to Equity and Debt Ratio would fall and profitability ratios such as Gross Profit Margin and Operating Profit Margin would rise.

On the statement of cash flow no relevant change should be noticed for tax purposes it is probable that Apple would continue to defer revenues and consequently taxes.

What were the reasons behind introduction of Non-GAAP financial measures by Apple Inc. in 2008? What was the reaction of investment community?

It is believed that both GAAP and Non-GAAP accurately reflect Apple’s economic reality. Each method just simply presents Apple’s financial data in a different way. Under GAAP, revenue from iPhone is deferred and is recognized on a straight line basis over a 24 month period. This type of subscription accounting is required because Apple chose to give future, free software upgrades with the iPhone. GAAP requires this to prevent companies from trying to over inflate revenues by increasing sales with the promise of a free incentive in the future then not delivering on the promise.