By Daniel Eran Dilger
Published: 01:30 PM EST (10:30 AM PST)
Apple, 802.11n, and Sarbanes-Oxley
The first products Apple delivered that were impacted by the new rules were MacBooks with
802.11n WIFi hardware features. Apple sold the notebooks and recognized revenues at their time of sale, but it did not advertise the equipment's latent capacity to support the higher speed wireless networking because the technology was still undergoing the final stages of its draft specification.
Once the final draft for 802.11n was completed at the end of 2006, Apple released new AirPort base stations and MacBooks with faster 802.11n WiFi features and offered its existing MacBook users the ability to activate the secret feature on their own notebooks for a $5 fee (later reduced to $1.99), citing Sarbanes-Oxley regulations.
The company was assailed for charging the nominal fee as lots of accountants lined to testify that the law does not specifically require payments for such upgrades, but only forces companies to estimate the value of any post-sale upgrades and withhold the booking of that revenue, something that Apple had not done when it first sold the MacBooks with better hardware than advertised.
The iPhone and subscription accounting
In response to the heated imbroglio that erupted in the tech press over Apple's $2 fee for its optional 802.11n software driver upgrade, the company decided to account for new hardware it expected to upgrade over time on a subscription basis instead.
As Oppenheimer explained in Apple's FQ2 2007
conference call, "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. 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."
This decision invoked the wrath of shareholders, who suddenly realized that the massive revenues Apple would be earning on iPhone sales would not show up immediately in the company's revenue reports. Instead, the revenues would slowly appear over time, delaying their ability to make short term profits. Had Apple instead recognized this revenue immediately, its stock would be expected to rise rapidly as iPhone revenues poured in immediately.
Apple blows a reverse revenue bubble
There was nothing extraordinary about Apple's subscription accounting; magazine publishers similarly accept annual subscription fees and then book monthly revenue as they deliver each issue to their readers. This results in the exact opposite of Enron's scandalous "mark to market accounting." Rather than booking lots of future revenue that may or may not appear, subscription accounting results in a company sitting on collected revenues that it does not immediately recognize (and therefore does not show up in the company's reported earnings).
While Apple announced blockbuster sales of iPhones, its reported revenues (and related metrics such as its profit to earnings ratio and earnings per share) only reflected a eighth of that quarter's revenue. This problem would eventually work itself out as Apple sold enough quarters of iPhones to begin adding up these fractional quarters' earnings together. However, because sales of the iPhone kept expanding so dramatically, the fractional installments of earlier quarters simply didn't add up fast enough.
The result was that by the end of 2007, Apple was realizing that subscription accounting was hiding vast millions in revenues from investors, the exact opposite problem of Enron. That encouraged the company to introduce the iPod touch using normal accounting, and to simply offer those users the ability to upgrade later at a nominal fee. The idea of charging $9.95 per year for an optional OS upgrade for the iPod touch again invoked the outrage of bloggers and pundits who found this outrageous.
Mr Jobs goes to Wall Street
In 2008, Apple really began paying for its decision to use subscription accounting on the iPhone. As the US dipped into recession, pundits began identifying Apple as a likely casualty of the sour economy because the company sold higher priced, premium computers and gadgets like the new iPhone and iPod touch. Additionally, they began to identify legacy iPod sales as weakening rather than simply being converted into iPhone sales, both in terms of units sold and in booked revenue.
This panic resulted in Apple's stock diving from nearly 200 to 113 in just two months ending in February 2008. Once it became clear that this fear was irrational, Apple again climbed back up to 188 in May 2008, followed by a second precipitous drop that drove the stock down into the 80s throughout the end of the year and into the first quarter of 2009.
This insanity drove Chief Executive Steve Jobs to make an uncommon appearance in the company's Q4 earnings call in October 2008 to implore investors and analysts to look at Apple's valuation based on its sales, not simply upon its officially recorded revenue under GAAP (Generally Accepted Accounting Principles) rules. The company for the first time presented non-GAAP figures that showed what Apple's revenues would look if the Sarbanes-Oxley accounting rules weren't hiding $3.78 billion of the $4.6 billion in iPhone revenue from that quarter alone.
"I would like to go back and talk about the non-GAAP financial results because I think this is a pretty big deal," Jobs explained. "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 this 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."
Jobs also outlined that in terms of revenue, the company had become the world's third largest phone maker in just 15 months, behind Nokia and Samsung, but ahead of Sony Ericsson, LG, Motorola and RIM.
On page 3 of 3: How the new rules will affect iPhone users.
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