ENVS 1500 Lecture Notes - Lecture 7: Component-Based Software Engineering

Accounting for the 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 about the non-GAAP financial results,because I think this is a pretty big deal. In addition to reportingan outstanding quarter, today we are also introducing non- GAAPfinancial results, which eliminate the impact of subscriptionaccounting. Because by its nature subscription accounting spreadsthe impact of iPhone’s contribution to Apple’s overall sales, grossmargin, and net income over two years, it can make it moredifficult for the average Apple manager or the average investor toevaluate the company’s overall performance. As long as our iPhonebusiness was small relative to our Mac and music businesses, thisdidn’t really matter much, but the past quarter, as you heard, ouriPhone business has grown to about $4.6 billion, or 39% of Apple’stotal business, clearly too big for Apple management or investorsto ignore.2
Jobs also noted that in terms of non-GAAP mobile-phone revenue, injust 15 months Apple had become the world’s third-largest phonemanufacturer behind Nokia and Samsung but ahead of Sony Ericsson,LG, Motorola, and RIM.

Company Background
Jobs and Steve Wozniak launched the personal computer revolution inthe 1970s with the Apple II. In 1984, the Apple Macintosh, with itsease-of-use and brilliant design, redefined the personal computer.Shortly thereafter, Jobs left the company, returning in 1997. UnderJobs, Apple catalyzed the digital-media industry with the launch ofits iPod portable musical player in October 2001, followed by theintroduction of its iTunes online store in April 2003.

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 July 2008 along with itssecond-generation mobile operating system (iOS 2). Also in July2008, Apple introduced its App Store, which offered iPhone and iPodtouch users a wide variety of mobile applications ranging fromgames to social networking to productivity tools, mostly pricedunder $10. On July 14, 2008, Jobs noted, “The App Store is a grandslam, with a staggering 10 million applications downloaded in justthree days. Developers have created some extraordinaryapplications, and the App Store can wirelessly deliver them toevery iPhone and iPod touch user instantly.”3 Many of theapplications took advantage of the more robust iOS 2. By October2008, Apple was best known for its technical and design innovation,its “walled garden” approach (i.e., its mostly proprietaryecosystem of hardware, operating and application software, andperipherals), and its premium-priced products.

iPhone Business Model
The original iPhone 8GB model had a U.S. retail price of $399 andwas available through Apple and AT&T, the iPhone’s exclusiveU.S. mobile carrier. In the U.S., mobile carriers typicallyprovided subsidies to phone manufacturers, which lowered thepurchase price of the new phone. In exchange, most consumers signeda two-year service contract with the carriers. Apple and AT&Tagreed to a different arrangement, but did not disclose itsspecifics. AT&T did not subsidize the iPhone; instead, Applesigned a revenue-sharing agreement with AT&T that gave Apple ashare of the subscribers’ monthly service fees. Needham & Co.analyst Charles Wolf believed that AT&T paid Apple $10 permonth over a typical two-year contract.4 In addition, althoughApple did not disclose how much it sold the iPhone for to AT&T,analysts believed that Apple made an estimated $120 in gross profiton every iPhone sold.5
At the iPhone’s launch, Apple announced it might periodically offernew software updates and upgrades free of charge to its iPhonecustomers. In contrast, Mac and iPod users did not receive freesoftware 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 ofthe iPhone operating system free of charge to all iPhone users.Apple’s chief financial officer Peter Oppenheimer explained, “SinceiPhone customers will likely be our best advocates for the product,we want to get them many of these new features and applications atno additional charge as they become available.”6
In addition, Apple’s management knew that smartphone users wereslow to update their software, and that few opted to buy upgrades.Therefore, the company believed it was necessary to offer newsoftware features free of charge to increase user acceptance. Incontrast, most other mobile software vendors reserved new softwareupdates for new hardware (i.e., phone) releases.7 Apple, AT&T,third-party application developers, and users would all benefitfrom consumers’ use of the latest operating system andapplications, giving Apple and its ecosystem a competitiveadvantage. AT&T would run a more effective and efficient mobilenetwork; third-party software developers would have a stablehardware and software roadmap; Apple could delist applications fromits App Store that weren’t written for its latest operating system;and all the while, iPhone users would benefit from an evolving anddifferentiated set of features and functionality. Many usersofcompeting mobile-phone platforms could not upgrade to neweroperating systems and applications because of compatibility issueswith their phones.
When Apple launched the iPhone 3G in July 2008, it revamped itsbusiness model, bringing it more in line with industry practices.Apple gave up its share of the monthly service revenue in exchangefor AT&T subsidizing the price of the iPhone 3G, which sold for$199 at retail. Again, the two parties chose not to disclose thespecifics of their arrangement, but the subsidy was estimated at$300 per phone sold.8 Apple continued to differ from most otherindustry participants when it offered existing iPhone usersupgrades to its second-generation operating system at nocost.
By August 2008, a month after Apple introduced its App Store, Jobsnoted that users downloaded more than 60 million programs for theiPhone, and Apple was averaging $1 million a day inapplication-software revenue. Apple received 30% of the App Storerevenue from the sale of an iPhone application, and the developerreceived the remaining 70%.9 Jobs stated, “Phone differentiationused to be about radios and antennas and things like that. Wethink, going forward, the phone of the future will bedifferentiated by software.”10
Also in August 2008, the New York Times reported that T-Mobilewould be the first carrier to launch mobile phones using Google’sAndroid mobile operating system; the phones were expected to hitshelves in late October 2008. On October 21, 2008, Google announcedthat Android was now “the first free, open source, and fullycustomizable mobile platform.”
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 we will be periodically providing new software features toiPhone customers free of charge, we will use subscriptionaccounting and recognize the revenue and product cost of goods soldassociated with iPhone handset sales on a straight line basis over24 months. So while the cash from iPhone sales will be collected atthe time of sale, we will be recording deferred revenue and costsof goods sold on our balance sheet, and amortizing both of theminto our earnings on a straight line basis over 24 months. We willcontinue to expense our iPhone engineering, sales, and marketingcosts as we incur them. This accounting policy will have no impacton cash flow or the economics of our business.12
In contrast, Apple generally recognized revenue and cost of salesfor its other software-enabled hardware products such as Macs andiPods at the time of sale (i.e., immediate revenue recognition)under SOP No. 97-2. This was because the company did not providenew features or software applications for those products free ofcharge. (See Exhibit 2 for the FY 2008 financial statement noterelating to Apple’s revenue recognition policies under GAAP.)
Apple’s decision to use subscription accounting for the iPhone camesoon after the company faced consumer backlash over a $5 upgradefee (later reduced to $1.99) it charged new MacBook buyers.13 In2006, Apple sold its latest MacBook with a wireless chip that wouldallow users to access the new and better Wi-Fi 802.11n technologyonce it became available and the chip was activated withsoftware.Apple did not tell MacBook buyers about the chip’s existence, andit also recognized all revenue at the time the MacBooks sold. Thus,the chip and its activation software were an unspecified, futureupgrade that did not have an established, objective, separate value(which would have allowed it to be accounted for separately) at thetime of the MacBook sale. To comply with GAAP, Apple faced twooptions: 1) restate its financials to recognize the MacBook revenueunder subscription accounting, or 2) charge users for the upgrade.The company chose the latter option.
Technology companies such as Apple were increasingly facing theissue of how to account for bundled components as the software andhardware in these products became more integrated and integral tothe products’ function. This placed U.S. technology companies onunequal footing with their overseas competitors becauseInternational Financial Reporting Standards (IFRS) allowedcompanies to use a more subjective measure—cost plus margin—when anobjective and separate value could not be established for a futuredeliverable such as a free software upgrade. Consequently, anoverseas company could report more than a fraction of its revenuewhen it sold a bundled component with the promise of a futuredeliverable such as a free upgrade. Company management couldestimate the cost and the margin of the upgrade and defer just thatportion of the bundled component’s sale until the upgrade wasdelivered.Subscription Accounting
The software and magazine publishing industries were well known fortheir use of subscription accounting. Magazine publishers reportedthe cash received for a subscription at the time that thesubscription was purchased, but recorded the revenue only as eachissue was delivered. The remaining balance was deferred into aliability account called unearned (or deferred) revenue. Forexample, if a year’s subscription of a monthly magazine cost $12,then the magazine publisher would recognize $1 per month in revenuefor 12 months as the unearned revenue account decreased by $1 permonth.
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
In July 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-called deferred earnings are adding up, and someprofessional Apple watchers are starting to realize that theirimpact could be substantial .... And to the dismay of Appleshareholders, the fact that these deferred earnings are piling upseems to have gone right over the heads of the institutionalinvestors who have driven Apple shares down nearly 75 points sinceDecember.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, the Securities and Exchange Commission (SEC) issued newnon-GAAP disclosure rules to address concerns about the lack ofoversight on these disclosures. The SEC’s Regulation G requiredcompanies that disclosed non-GAAP financial measures to use themost comparable GAAP measures when preparing their non-GAAPdisclosures, in addition to providing a reconciliation of the GAAPand non-GAAP results.20 Recent studies indicated that since thepassage of Regulation G, firms were less likely to provide non-GAAPearnings that excluded expenses of a recurring nature.21
In describing Apple’s non-GAAP financials, Jobs noted that iPhonenon-GAAP sales were a staggering $4.6 billion, 39% of Apple’s totalrevenue in the fourth quarter of 2008. See Table A.

Apple cautioned that its non-GAAP calculations did not adjust forthe estimated costs associated with its plan to provide newfeatures and software upgrades to iPhone buyers free of charge. Italso warned investors that these figures were not prepared under acomprehensive set of rules or principles, since no standardsexisted for making these calculations. (See Exhibit 5 for Apple’scautions on use of its non-GAAP supplements.)
Apple also announced iPhone Q4 of FY 2008 GAAP sales that justmissed Wall Street’s estimates, but total income that easily beatanalysts’ estimates.22 Apple’s guidance for the first quarter of FY2009 was well below Wall Street’s forecast. Apple’s stock closeddown for the day.
Conclusion
The immediate analyst reaction to Apple’s Q4 of FY 2008 financialresults and conservative Q1 of FY 2009 guidance was largelypositive, 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 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 Reactionto Apple’s decision to provide non-GAAP supplements was more mixed.Proponents of Apple’s use of non-GAAP supplements argued that theseresults were 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 provide non-GAAPsupplements during earnings releases. Only time would reveal theireffects, if any, on Apple’s share pricing.

Discuss GAAP, non-GAAP numbers and their impact on financialstatements

2. Which method best reflects the economic reality?

3. Should Apple lobby for their non-GAAP numbers to besanctioned by FASB?

4. Does it matter if the revenue recognition rule for smartphone changes?