OULU BUSINESS SCHOOL

Joona Lahti Matti Keskitalo Meija Ronkainen

REPORT ON THE CASE: ACCOUNTING FOR THE IPHONE AT APPLE INC.

Term Paper Financial Analysis and Firm Valuation December 2012

CONTENTS

REVENUE RECOGNITION AT APPLE ........................................................ 3

THE EFFECTS OF TWO METHODS ............................................................ 5

EFFECTS IN FINANCIAL RATIOS ............................................................... 7

CHOOSING THE SET OF RATIOS ................................................................ 9

OTHER ACCOUNTING METHODS ............................................................ 11

BENEFITS AND COSTS OF CHANGE IN ACCOUNTING RULES ....... 12

POSSIBLE MOTIVES FOR DISCLOSING NON-GAAP EARNINGS ..... 14

RECOMMENDATION REVISIONS ............................................................. 16

APPENDICES ................................................................................................... 17

10 SOURCES.......................................................................................................... 19

3 1 REVENUE RECOGNITION AT APPLE

In June 2007 Apple entered to the highly competitive phone market with its iPhone 8GB. Apple sold its phones through AT&T that was iPhones exclusive U.S. mobile carrier. Mobile carriers typically provided subsidies to phone manufacturers, making the purchase price of the new phone lower to the customers. In exchange to this low purchase price carriers demand consumers to write two-year service contract with the carriers. However, Apple made the agreements differently with the carrier, which meant a revenue sharing agreement with AT&T that gave Apple a share of the subscribers monthly service fees.

When Apple launched the iPhone 3G in July 2008, they changed their business model and gave up the monthly service revenue and let AT&T subsidize the price of the iPhone 3G. The retail price lowered till $199 and Apples subsidy was estimated at $300 per phone sold.

Apple's iPhone, Macs and iPods' revenue recognition was in general, as all the software-enable hardware products, under the rules of the software revenue recognition determined by the American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) No, 97-2. These accounting standards required dividing up the sales over the length of the licensing contracts. Software-enable hardware products were also guided by these standards.

After the first iPhone launch 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. This method meant that the cash from the iPhone sales would be recorded at the time of sale but the revenue and cost of goods sold deferred to the balance sheet. Both of them would be amortized into earnings and costs on a straight line basis over 24 months that was considered to be the useful life of the device.

In contrast, Apple did not use this revenue recognition to Macs and iPods. To comply with the GAAP, Apple had two options: either start using the revenue subscription accounting or charge users for the upgrade and use immediate revenue recognition under SOP 97-2 that enabled to recognize the revenue at the time of sale. Apple

4 chose the latter option and advocated the decision by the fact that these products did not provide free of charge new features or software applications but iPhone did.

Apple gave free of charge software features and upgrades to the iPhone users because they believed that they were their biggest advocates. Secondly Apple knew how hard it was to get smartphone users to update their software or even pay for it. It also brought a competitive advantage to Apple towards competitors when iPhone users had constantly the newest operating system. Now AT&T would run more effectively, software developers would create better new applications and Apple could now easily remove old applications that werent written for its latest operating system from its App Store when the competitors were struggling with the compatibility issues with their phones' old platforms and new applications.

5 2 THE EFFECTS OF TWO METHODS

The accounting method under GAAP that Apple had been using means that the revenues and costs of iPhone sales are spread over a 24-month period. On balance sheet, this means recording deferred revenue and costs of goods sold and amortizing both of them into the earnings on a straight line basis over 24 months. Engineering, sales and marketing costs are recorded as they incur. On cash flow this method has no effect.

Now when Apple announced its quarterly results, the iPhone sales in income statement reflected only an eight of the whole iPhone sales revenue and cost of goods sold on that quarter, which made the companys profit seem less than it actually was. The rest of the cost of goods sold is increasing the assets and the rest of the revenues are increasing the liabilities on the balance sheet. For Apples other software-enabled hardware products, Apple recognizes the revenues and costs at the time of sale. Apple uses this immediate revenue recognition on other products than iPhone because it does not offer new features or software applications free-of-charge.

The non-GAAP method that Apple released on September 27 2008 stated better quarterly revenue and net profit of 11.8 billion dollars and 2.4 billion dollars. It eliminates the impact of subscription accounting, where deferred revenues were adding up. The GAAP method makes it more difficult for the average Apple manager or the average investor to evaluate the companys overall performance. However, it gives a lot of weight on iPhone. Under the non-GAAP method Apples true performance is better stated on the companys income statement and balance sheet.

The GAAP method of accounting affects the financial statements so that less income is recognized at the point of sale and revenues are deferred until the new features are provided. This means also paying less tax at the point of sale and having more income and costs when the updates are downloaded. The non-GAAP method

6 eliminates the effect of deferred revenues piling up and makes the financial statements better inform Apples financial situation.

7 3 EFFECTS IN FINANCIAL RATIOS

Financial ratios are often used in accounting for evaluating the companys overall financial condition. Financial ratios are used by managers within a firm and companys potential shareholders and creditors.

By the fourth quarter of 2008, Apple decided to announce non-GAAP financial results along with the basic GAAP numbers. This was by the fact that subscription accounting under GAAP had too big impact to companys financials to ignore. This gave people their first look at Apples revenue numbers without the use of subscription accounting.

Next we will examine what the effect to Apples financial rations is between GAAP and non-GAAP results on September 27, 2008. Non-GAAP values used in ratios are calculated simply by removing the impact of deferred revenues from the total amount of GAAPs balance sheet.1

GAAP Profitability Ratios Net Profit Margin (%) Return on Assets (ROA) (%) Return on Equity (ROE) (%) Liquidity Ratios Current ratio Quick ratio Operating cash flow (%) Solvency Ratios Long-term solvency ratio (%) Debt-to-Equity (%) Debt Ratio (%) 14.40 2.87 5.40

Non-GAAP 20.80 7.69 11.59

2.46 1.91 68.00

4.53 4.33 154.50

8.60 188.17 46.86

27.30 50.69 33.64

Net profit margin shows the amount of each sales dollar left over after all expenses have been paid. It is the key factor of determining companys profitability and useful in comparing it to similar industries. ROA shows the percentage of profit that

Please see the appendices for more detailed information about the used numbers and formulas.

8 company earns in relation to its total assets, in other words it is the amount of profit made by a company per dollar of its assets.

We can see that the profitability ratios are much better in non-GAAP calculations. GAAP calculations using the subscription method give a rather less good picture of the companys overall profitability because of the deferred earnings.

Liquidity ratios give also better results with the non-GAAP calculations comparing to GAAP. This is because the deferred revenue is written as a liability on the balance sheet in GAAP calculations.

Generally, the higher the companys liquidity ratios are, the better it can turn the companys short-term assets into cash to cover its debts. One thing to recognize is that in both calculations the current- and quick ratios are very good, far better than one, which is the minimum rate of good liquidity. Operating cash flow ratio tells how well current liabilities are covered with the cash flow generated from companys operations. It is twice as good calculated with non-GAAP than GAAP.

Solvency ratio gives a measurement how likely a company will be to continue after facing its whole debt. Non-GAAP calculations give much better results comparing to GAAP calculations when measuring solvency ratio.

9 4 CHOOSING THE SET OF RATIOS

We form a set of ratios that we consider to be the best. The profitability ratio we choose is profit margin, since it is useful in comparing this company to other firms in the same industry. Net profit margin tells us how much a companys sales generate profit. As a liquidity ratio we choose current ratio, since it describes liquidity even in long term. We choose debt-to-equity as a solvency ratio. This is because it is used commonly and tells us the companys financial leverage.

We consider net profit margin as a good profitability ratio since it gives a clear picture of the money left in the firm when all the costs are paid. The higher the profit margin, the better control the company has over its costs and therefore is profitable. If a company increases its revenues, profit margin doesnt necessarily increase with the revenues and so its a very stable ratio. Apples GAAP net profit margin is 14.4%, while the industry net profit margin is 14%.2 Non-GAAP exceeds this very drastically. This means the GAAP net profit margin is a very sensible choice. On the other hand, Non-GAAP net profit margin of 20.8% reflects the high profit from the iPhone sells.

Current ratio measures the capability of a company paying its short-term debt with its short-term assets. It tells us whether Apple might go into bankruptcy if it paid all its debts and didn't access for more financing. If current ratio was below 1, the company would be unable to pay off its obligations. As the industrys current ratio is 1.44 and Apples GAAP current ratio 2.46 and non-GAAP 4.53, companys liquidity is relatively good. Current ratio reflects companys ability to turn its product into cash. This shows in the great increase in non-GAAP current ratio. It reflects Apples great ability to generate cash. This wasnt clear for most investors before non-GAAP financial results were published. Debt-to-equity ratio measures a companys ability to meet its long-term obligations. High ratio means that the company has been aggressive in financing its growth with

Industry ratios are checked from www.stock-analysis-on.net, dated on Jun 30, 2008

10 debt. Industry debt-to-equity is about 30% and Apples GAAP is about 188%, which is very high. The smaller D/E ratio of non-GAAP that is about 51% is explained by the removal of the impact of iPhone updates. This also shows the significance of the iPhone in the financial reports of Apple. All the ratios in our set were improved in the non-GAAP method. Its a matter of opinion if the non-GAAP numbers are thought to reflect Apples financial situation better. However, we choose non-GAAP method to be better. IPhones significance to Apple is so big that it cannot be ignored and ignorance is what GAAP financial report did. Our ratio calculations support this view. In net profit margin we consider the non-GAAP ratio to be better because in the case it became obvious that Apple is better than industry on average. In current ratio we think the non-GAAP number to be better because of Apples great ability to generate cash and therefore the non GAAP number makes more sense. What comes to debt-to-equity ratio, we think the non-GAAP ratio is better because it takes iPhone into account more clearly.

11

OTHER ACCOUNTING METHODS

There are other possible methods of accounting besides from subscription accounting and Apples alternative accounting method. Apple could remove the impact of updates. One way is to make the updates subject to a charge again and another could for example be to make the App Store to be based on a monthly fee. These both methods cause that in accounting iPhone sales match the real life revenues of iPhone sales and updates are recorded in accounting as a separate lot.

One option could perhaps be leasing the iPhone to customers. In this leasing agreement customer would only have the right to use the device including software updates in a certain amount of leasing fee per month. The leasing period would be the device's useful life that was approximated to be two years. At the end of this period the customer could decide whether to return the device back to the company or purchase it at a fair price. This would be a good way for Apple to acquire customers because leasing the device is much cheaper than straight buying and the customer could also benefit from the option to purchase the device at the end of the period. This accounting method, called capital leasing, is recognized both as an asset and as a liability in the lessees balance sheet when the agreement is signed. The lessee can also make depreciation each year on the asset and deduct the interest expense component of the lease payment each year. At a lessors point of view leasing is like a capitalized loan with interests that lessee pays back for example on a monthly basis and this way the lessor gains revenue. The reason why Apple didnt propose any other methods is in our opinion that the company wanted to maintain the advantage on market. Keeping the updates seemingly free-of-charge makes Apples customers more willing to update their phones and download new apps.

12

BENEFITS AND COSTS OF CHANGE IN ACCOUNTING RULES

Apple has spread the revenue over two years because it provides free software updates over the life of the phone. Simultaneously Apple gets all the cash upfront from iPhone revenue. It has produced extraordinary cash flow relative to reported earnings in recent years.

It is clear that the company's GAAP earnings have never fully reflected the good profitability of the iPhone. Change in accounting rule SOP 97-2 could eventually allow Apple to book most of the revenue upfront and it wouldn't change the company's cash flow. There would be no change in theoretical value.

However, lobbying FASB would be beneficial to Apple because if the accounting rules changes it would cause Wall Street analysts to increase the earnings estimates. Reported earnings would be remarkably increased. After this Apple's stock would look cheaper to unsophisticated investors. Therefore it might also act as a catalyst for the stock.3

The difference is massive. Non-GAAP net sales were 48% bigger than GAAP net sales in the third quarter of 2008. Non-GAAP EPS was over 113% greater than GAAP EPS.4 On the other hand, GAAP EPS may actually be higher than current non-GAAP. Under the new rule Apples results would be inflated. They would get revenues for current iPhones and additionally the revenue of devices sold over the prior two years.

By catalyst we mean an event that directly or indirectly causes another event, in this case positive earnings report to be a catalyst for a stock to rise in price.
4

(Non-GAAP Earnings per diluted common share - GAAP Earnings per diluted common share) / GAAP

Earnings per diluted common share) = 2.69 1.26 / 1.26 = 113.5 %

13 The full compliance of this method isn't an easy task for Apple. It would not take prior sales into account, and the valuation of software updates isn't easy for investors to forecast.

Overall, despite the fact that the change wouldn't change the cash dynamics at apple, it would make it easier for investors to understand the great cash earnings power of iPhone. Apple would benefit with better earnings estimates and reported earnings as well.

14

POSSIBLE MOTIVES FOR DISCLOSING NON-GAAP EARNINGS

As Apples CEO Steve Jobs said, the non-GAAP results eliminate the impact of subscription accounting. Namely, in the accounting method under GAAP rules, Apples deferred earnings add up and as an impact, Apples average managers and investors cant see the companys true state. In addition, a good accounting method is needed because Apple has become the worlds third largest phone manufacturer and thus a lot of weight is put on the company.

The non-GAAP financial measures are intended for the limited purpose of presenting performance measures that include the total sales, related product costs and resulting income for iPhones and Apple TVs in the period those products are sold to customers. They provide greater transparency, of which the investors benefit and therefore can better forecast and analyze Apples future performance. However, even though the non-GAAP measures are a good way to measure Apples performance, they should not be the only measure to be shown or used in analyzes, because they are not prepared in accordance with GAAP or any other comprehensive set of rules or principles.

Comparing to GAAP, the non-GAAP method is not as complicated. Because investors weighted the non-GAAP results more heavily compared to GAAP in expectations of future performance, Regulation G was issued by SEC in 2003. Since the passage, firms are less likely to provide non-GAAP earnings that exclude expenses of a recurring nature. This regulation makes disclosing the non-GAAP earnings more secure as the investors might not be weighting them too heavily. The reported non-GAAP earnings are more consistent with Apples cash and short term investments. Also the valuations in this method better indicate the companys true financial performance. The GAAP proponents argued that iPhone was given too much weight in non-GAAP method and referred to the fact that the numbers then became more sensitive. But, if the case is that iPhone unit sales are volatile and difficult to predict, shouldnt this risky part be informed, not hidden under other numbers? All in all, if non-GAAP earnings are disclosed and not analyzed alone,

15 they are great information from which to see Apples true performance and predict its future.

16 8 RECOMMENDATION REVISIONS

Apples financial results changed very radically when presented in non-GAAP form. At first, it may look suspicious before getting into it more deeply.

Analysts reacted to non-GAAP publication mainly positively. Of course not all shared the same view. Situation in the technology industry was impacting to the revisions of whole markets and therefore to Apple as well. Estimates were lowered in December 2008 for Google and Research in Motion as well.5

The direction of recommendation change depended on whether analyst was GAAP proponent or not. Non-GAAP financial statement had its advantages and disadvantages. The negative sides of using non-GAAP were penalization by the Street and giving too much weight to iPhone. Therefore quarterly numbers became more sensitive to unit sales. A positive side was that non-GAAP reflected the cash and short-term investment better and generally valuation calculations were more accurate and reflected true financial performance better. Now strong shipments of Q4 2008 were also included in results. As Shebly Seyrafi of Caylon Securities noted, Apples earnings-pre-share would have more than doubled had it not been for the companys use of subscription accounting for iPhone sales. This revealed the great capability of iPhone to make earnings and must have been one of the greatest reasons why most of the analysts raised their ratings. As a reference to above, we would upgrade the ratings of the Apples stock. According to Bowen, Davis and Matsumoto in 2004, investors weight non-GAAP numbers more heavily when they form expectations for future earnings. Our revision would have been profitable if adopted, since the stock price increased 18% till the end of the month.

http://www.bullfax.com/?q=node/6562

17 9 APPENDICES

Appendix 1: The numbers used in the ratio calculations.

Net Sales Net income Total deferred revenue Total current assets Total assets Total current liabilities Non-current liabilities Total liabilities Total shareholder equity Total liabilities and Shareholders equity EPS per diluted common share

GAAP 7,895 1,136 7,882

Change +3,738 +1,301 0

Non-GAAP 11,682 2,437 7,882

34,690 39,572 14,092 4,450 18,542 39,572 39,572

+2,437-1,136-7,882 -7,882 -7,882 0 -7,882 -18,542 -7,882

28,109 31,690 6,210 4,450 10660 21,030 31,690

1.26

113.5%

2.69

18 Appendix 2: Financial ratios used

Profitable ratios:

Liquidity ratios:

Long term solvency:

19 10 SOURCES

Haarala, Risto et al. (toim.): Suomen kielen perussanakirja. Edita, 1996.

http://www.businessinsider.com/henry-blodget-new-apple-iphone-accountingchange-could-send-profits-and-stock-to-moon-2009-9 (7.12.2012)

http://www.bullfax.com/?q=node/6562 (13.12.2012)

www.investopedia.com (13.12.2012)

http://www.stock-analysis-on.net/ (13.12.2012)

http://www.justanswer.com/finance/4r8nk-identify-two-recognized-leaseaccounting-methods-lessees.html (13.12.2012)