Apple Inc.’s CEO Steve Jobs announced the iPhone at a media event in January 2007. Apple released the iPhone in the US at 6 pm on Friday, June 29, 2007 to unprecedented fanfare, long queues and largely rave reviews. Initial pricing of the iPhone was $499 for the 4 gigabyte model and $599 for the 8 gigabyte version. Apple sold 270,000 iPhones during the first 30 hours, making the iPhone the most successful new product release in Apple’s history. A spokesman for Apple’s partner, AT&T, said, ‘We’ve sold more iPhones in the first weekend than we’ve sold in the first month of any other wireless device in AT&T’s history.’
Despite the impressive start, the company disclosed in their third quarter conference call with analysts that total revenue from iPhone sales was only $5 million – an average of less than $19 per iPhone and an insignificant amount compared to the quarter’s total net sales across all products and services of over $5.4 billion (Exhibit 1). During the question and answer portion of the call, the company disclosed that the ‘vast majority’ of reported iPhone revenue was due to the sale of accessories – not the phones themselves. Further, the company had expensed other operating costs related to the iPhone including R&D, Sales and Marketing. These latter costs were unusually high before and during the launch period because of a large increase in advertising and extra staffing in customer support and in Apple’s online and physical stores. There seemed little doubt that iPhone cost of sales combined with these other operating expenses amounted to far more than the $5 million of reported revenue. The seeming disconnect between the iPhone’s widely touted launch success and its apparently poor initial financial performance was likely due to Apple’s unusual choice of a revenue recognition policy for the iPhone called ‘subscription’ accounting.
Revenue recognition at Apple
Apple listed ‘revenue recognition’ among its critical accounting policies and estimates. Like the overwhelming majority of businesses, Apple had consistently used ‘point-of-sale’ revenue recognition for hardware sales including the Macintosh and the iPod. That is, 100 percent of the sale price was recognized as revenue when a product was shipped to a customer. The usual allowances were made for sales returns, uncollectable accounts and warranty costs. Some customers purchased directly from Apple via its online store or one of more than 170 physical Apple Stores. Other customers were resellers such as Amazon.com and Best Buy.
Revenue recognition and the ‘N’ generation wireless upgrade
In January 2007, Apple announced it had built in nextgeneration wireless ‘N’ capability in selected Macintosh laptop and desktop computers that it had been selling since the previous September. However, in order to activate this new built-in ‘N’ standard, Apple required customers to pay $1.99 for software to turn on the feature. This previously unannounced upgrade fee created heated discussion on the Internet. Most bloggers and forum participants were negative about charging for something already inside the computer. Apple blamed the nominal charge on accounting standards, and reporters discussed Apple’s accounting conundrum (Exhibit 2).
Apple said it is required under generally accepted accounting principles to charge customers for the software upgrade. ‘The nominal distribution fee for the 802.11n software is required in order for Apple to comply with generally accepted accounting principles for revenue recognition, which generally require that we charge for significant feature enhancements, such as 802.11n, when added to previously purchased products.’ Source: CNET News.com January 18, 2007. ‘Apple is blaming the Generally Accepted Accounting Principles (GAAP) (. . .). Apple claims that those rules require the firm to charge for significant product updates – such as providing next generation wireless networking. Leave it to the accountants to spoil a good thing. In the heads of the bean counters, shipping a feature in disabled mode without telling the buyer and then enabling it at a later point amounts to shipping them a free 802.11n wireless networking card.’ Source: SiliconValleySleuth.com
Revenue recognition for Apple TV and the iPhone
A few months later, Apple announced its revenue recognition policy for the recently shipped Apple TV and its forthcoming iPhone.
‘In March 2007, the Company began shipping Apple TV and expects to begin shipping the iPhone in late June 2007. For Apple TV and the iPhone, the Company plans to provide future unspecified features and additional software products free of charge to customers. Accordingly, the sale of the Apple TV and the iPhone handset are accounted for under subscription accounting in accordance with Statement of Position (‘SOP’) No. 97-2. As such, the Company defers the associated revenue and cost of goods sold at the time of sale, which will then be recognized on a straight-line basis over the currently estimated 24 month economic life of these products. Costs incurred by the Company for engineering, sales, and marketing will continue to be expensed as incurred.’ Source: Apple, Inc. 10-Q, May 10, 2007. (See Exhibit 3 for Apple management’s further discussion of revenue recognition).
In short, Apple elected to use subscription accounting similar to that used by magazines. When a customer orders and pays for a two-year magazine subscription, the magazine records the increase in cash but defers the associated revenue as a liability. Revenue is earned and cost of sales is expensed ratably over the two-year period as each magazine ships.
In an interview with the New York Times, Apple CFO Peter Oppenheimer said ‘Apple planned to regularly add new software features to iPhones after they are sold, at no charge, and would alter its accounting policies to make this possible.’ Further, CEO Steve Jobs indicated that upgrades gave the iPhone an advantage since software in other phones generally remained unchanged.
Why did Apple switch to a subscription model for revenue recognition for its two newest products? Was it merely a response to the negative reaction to the $1.99 fee it charged customers to activate next-generation wireless on their previously purchased laptops?
Required
1 Estimate the amount of revenue Apple recorded under the subscription model from iPhone (not accessory) sales beginning 6 pm Friday June 29, 2007 and ending Saturday June 30, 2007 – the last 30 hours of Apple’s third fiscal quarter. Estimate the amount of revenue Apple could have recorded if all revenue had been recognized at the point of sale. (Hints: (a) Since some iPhones were sold at AT&T stores and some were the lower-priced 4 gigabyte model, assume Apple received on average $530 per iPhone sold. (b) Do not attempt to estimate revenue for the Apple TV since unit sales were not provided. (c) Ignore potential allowances for sales returns, uncollectible accounts and warranty costs.)
2 During the July 2007 conference call, Apple management estimated they would sell one million iPhones by the end of their fiscal year, September 30, 2007, i.e., 270,000 from the third quarter plus an estimate of 730,000 in the fourth quarter. What amount of revenue would Apple record under the subscription model assuming the company sold an additional 730,000 iPhones during their fiscal fourth quarter? (a) Ignore accessory sales and assume Apple received on average $425 per iPhone sold. (b) Again, do not attempt to estimate revenue for the Apple TV since unit sales were not provided, and (c) ignore potential allowances for sales returns, uncollectible accounts and warranty costs). Discuss the impact of the elimination of the 4 gigabyte model from the product line on September 5, 2007 and the lowering of the price of the 8 gigabyte iPhone to $399 on company revenues for the fiscal fourth quarter. (No calculations are necessary.)
3 Compared to the typical point-of-sale method, what are the likely effects on revenue, gross profit and net income in future quarters from Apple’s choice to use a subscription model for revenue recognition for the iPhone and Apple TV? (No calculations are necessary.)
4 Could Apple have structured sales of Apple TV and the iPhone to avoid ‘subscription accounting’? If so, how?
5 Assuming Apple could have avoided ‘subscription accounting’ for revenue recognition, speculate as to why Apple management might have preferred it anyway.
6 As an analyst evaluating Apple’s success, how would you compare Apple’s sales and gross profit across time and to other companies?
7 Speculate on Apple’s likely reasons for not using a subscription revenue recognition model for the iPod.
8 Could Microsoft make a similar argument for using subscription revenue accounting for their gaming system, the Xbox 360? If so, speculate on the pros and cons for Microsoft adopting a subscription model for revenue recognition for the Xbox 360.