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

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

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

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

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

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

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

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

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

9 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 iPhone’s 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 Apple’s 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 weren’t 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 company’s 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 Apple’s 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 company’s overall performance.

However, it gives a lot of weight on iPhone. Under the non-GAAP method Apple’s

true performance is better stated on the company’s 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 Apple’s financial situation.

7

3 EFFECTS IN FINANCIAL RATIOS

Financial ratios are often used in accounting for evaluating the company´s overall

financial condition. Financial ratios are used by managers within a firm and

company´s 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 company´s 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 Apple´s 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 GAAP’s balance sheet.1

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 company´s profitability and useful

in comparing it to similar industries. ROA shows the percentage of profit that

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

GAAP Non-GAAP

Profitability Ratios

Net Profit Margin (%) 14.40 20.80

Return on Assets (ROA) (%) 2.87 7.69

Return on Equity (ROE) (%) 5.40 11.59

Liquidity Ratios

Current ratio 2.46 4.53

Quick ratio 1.91 4.33

Operating cash flow (%) 68.00 154.50

Solvency Ratios

Long-term solvency ratio (%) 8.60 27.30

Debt-to-Equity (%) 188.17 50.69

Debt Ratio (%) 46.86 33.64

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 company´s 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 company´s liquidity ratios are, the better it can turn the

company´s 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 company´s

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 company’s 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 company’s 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 doesn’t necessarily increase with

the revenues and so it’s a very stable ratio. Apple’s 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 industry’s current ratio is 1.44 and

Apple’s GAAP current ratio 2.46 and non-GAAP 4.53, company’s liquidity is

relatively good. Current ratio reflects company’s ability to turn its product into cash.

This shows in the great increase in non-GAAP current ratio. It reflects Apple’s great

ability to generate cash. This wasn’t clear for most investors before non-GAAP

financial results were published.

Debt-to-equity ratio measures a company’s ability to meet its long-term obligations.

High ratio means that the company has been aggressive in financing its growth with

2 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 Apple’s 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. It’s a matter of

opinion if the non-GAAP numbers are thought to reflect Apple’s financial situation

better. However, we choose non-GAAP method to be better. IPhone’s 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 Apple’s 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

5 OTHER ACCOUNTING METHODS

There are other possible methods of accounting besides from subscription accounting

and Apple’s 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 lessee´s 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 lessor´s 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 didn’t 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 Apple’s customers more willing to update their

phones and download new apps.

12

6 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 Apple’s results would be inflated. They would get

revenues for current iPhones and additionally the revenue of devices sold over the

prior two years.

3 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

7 POSSIBLE MOTIVES FOR DISCLOSING NON-GAAP EARNINGS

As Apple’s CEO Steve Jobs said, the non-GAAP results eliminate the impact of

subscription accounting. Namely, in the accounting method under GAAP rules,

Apple’s deferred earnings add up and as an impact, Apple’s average managers and

investors can’t see the company’s true state. In addition, a good accounting method is

needed because Apple has become the world’s 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 Apple’s future performance. However, even

though the non-GAAP measures are a good way to measure Apple’s 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 Apple’s cash and short

term investments. Also the valuations in this method better indicate the company’s

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, shouldn’t 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 Apple’s true performance and predict

its future.

16

8 RECOMMENDATION REVISIONS

Apple’s 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, Apple’s earnings-pre-share would

have more than doubled had it not been for the company’s 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 Apple’s 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.

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

17

9 APPENDICES

Appendix 1: The numbers used in the ratio calculations.

GAAP Change Non-GAAP

Net Sales 7,895 +3,738 11,682

Net income 1,136 +1,301 2,437

Total deferred

revenue

7,882 0 7,882

Total current assets 34,690 +2,437-1,136-7,882 28,109

Total assets 39,572 -7,882 31,690

Total current

liabilities

14,092 -7,882 6,210

Non-current

liabilities

4,450 0 4,450

Total liabilities 18,542 -7,882 10660

Total shareholder

equity

39,572 -18,542 21,030

Total liabilities and

Shareholders’ equity

39,572 -7,882 31,690

EPS per diluted

common share 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-accounting-

change-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-lease-

accounting-methods-lessees.html (13.12.2012)