Accounting for the iPhone at Apple

ACCOUNTING FOR THE IPHONE AT APPLE, INC. 1.

ARTICULATE THE FINANCIAL STATEMENT IMPAC T OF THE ALTERNATIVE ACCOUNTING PROPOSED BY APPLE.

Apple proposed to recognize all revenues and COGS from the sales of iPhones in the quarter there are shipped/delivered (transfer of property and risk is transferred) instead of using the subscription accounting method demanded by US GAAP, which deferred the recognition of revenue and COGS up to 2 years (straight-line). Under Apple’s proposed method, equity position shown at the Balance Sheet would be much higher (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 Flows no relevant change should be noticed, for tax purposes it is probable that Apple would continue to defer revenues and consequently taxes. The table shown at the case exemplifies some of the impact

2.

UNDER APPLE'S PROPOSED ALTERNATIVE ACCOU NTING, THE RECONCILI ATION BETWEEN NET INC OME AND CASH FLOW FROM OPERATIONS NO LONGER REFLECTS C HANGES IN DEFERRED C OSTS AND REVENUES RE LATED TO SUBSCRIPTION ACCOUNT ING AS DISPLAYED UND ER THE GAAP NUMBERS. WHICH METHOD BEST RE FLECTS THE ECONOMIC REALITY?

iPhone represents the main source of revenue for Apple, under a scenario in which for some reason Apple does not sell any iPhone going forward it would still recognize for 2 years a huge amount of revenues in its Income Statement, due to the large amount of current and non-current deferred revenues (7.8B as Q4 2008FY). In addition, the free software upgrades Apple has suggested it will provide for iPhones and AppleTVs is likely to be a small percentage of these products economic value. In other words, the hardware and the first built-in software represent the biggest fraction of economic value (both for consumers and for Apple, data has shown that consumers usually do not immediately upgrade their devices with the latest operation system released). The substantial delivery of the product in quality and quantity occur at the time of sale. Having in mind that both methods have their shortcomings, it seems that the alternative method better reflects the economic reality. 3.

SHOULD APPLE LOBBY FOR THEIR NON-GAAP NUMBERS TO BE SANCTIONED BY FASB?

Yes, as discussed in question 2, an alternative to subscription method would better reflect economic reality of the company and would be a better source of information for decision makers, it worth to notice that IFRS allows for different treatment of bundled components with leaves Apple on an not fully justified disadvantage. Nonetheless, some form of adjustment should be done in the non-GAAP method proposed by Apple to account for the future costs of the free upgrades.

4.

DOES IT MATTER IF TH E REVENUE RECOGNITIO N RULE FOR SMARTPHONE CHANGES?

Over the long-term the economic impact and differences of recognizing revenue earlier rather than later should disappear, it should not have an impact on the true economic value of the company. Nonetheless, for all that have been discussed in the previous questions the impact on incentives can be material, for example, if Apple is not able to recognize revenues when sales occur and later it is faced with a significant drop in iPhone sales there could be an incentive to delay development and release of upgrades of its mobile operation system, in order hold some revenue to be recognized if sales continue to fall. In that case the long term strategy of the company could be tilted and the perspective to stakeholders and consumers could be harmed. The value of and the impact of this kind of incentives in the long term path of a company is highly subjective and hard or impossible to measure, but it remembers us that accounting, in this case revenue recognition rule, matters.