New rule could boost Apple's publicly reported earnings

[AppleInsider]

Apple's public accounting records could receive a significant boost, particularly in terms of iPhone profits, if a proposed rule change comes to pass.

The Financial Accounting Standards Board sets accounting standards for U.S. public companies, a power designated to the private, not-for-profit group by the Securities and Exchange Commission. According to Fortune Brainstorm Tech, the FASB has drafted a new rule that Apple heavily lobbied for -- a rule that one analyst told AppleInsider could influence the company's stock price.

"If the rule goes through, we believe Apple will be able to defer the iPhone revenue in a less dramatic manner," Piper Jaffray Senior Research Analyst Gene Munster said. "This could meaningfully alter the reported, GAAP-based revenue numbers in future quarters and the change would likely be a positive for the stock."

Under the current rules, Apple was forced to use "subscription accounting" in its iPhone-related filings -- a requirement that some believe masked the true profitability of the handheld device. The new rule is currently only in draft form, but if approved, history suggests it could cause dramatic increase on AAPL stock price.

"Subscription accounting meant that Apple has been under-reporting earnings on its bestselling smartphone for two years — one of the factors, Apple bulls believe, that kept its share price from fully reflecting the success of one most profitable products Apple has ever made," the report said.

Author Philip Elmer-DeWitt goes on to cite the hardware maker's third-quarter financial results. Though Apple reported profits of $1.35 per diluted share for the period ending June 27, its earnings per share under the non generally accepted accounting principles would have been $2.14 a share, a total nearly 60 percent higher.

The issue has existed for some time, and led some analysts to comment on what they called Apple's "real" quarterly earnings.

"At the heart of the problem for Apple is its decision to offer iPhone owners free software updates from time to time — a practice that required its accountants to spread the revenue from iPhone sales over the life of a cellphone contract, typically two years," Elmer-DeWitt said.

Apple has cited the generally accepted accounting principles (GAAP) as its reasoning for charging customers nominal fees for various upgrades, such as the iPod touch and Airport Extreme. Because Apple gives its iPhone software updates away for free, though, the Cupertino, Calif., company is required to spread its iPhone revenue over the length of the cell phone contract, which is usually two years.

Because of this, in August, Apple wrote to FASB Chairman Russell Golden in support of changing the rules. In the note, Betsy Rafael, Apple's vice president and corporate controller and principal accounting officer, said the current requirements to not accurately reflect the real economics of transactions. The proposed changes, they said, would address those issues.

"(The changes)... will result in a more accurate reflection of an entity's economic activities," wrote Rafael, "and in less complex and more transparent financial information that will better serve investors, financial analysts, and other users of financial statements."

[Ireland]

So the software updates aren't the issue at all then, the issue is the cellphone contract.

[AjitMD]

The market knows what Apple's non-GAAP real earnings are and the stock has priced that in. The non-GAAP PE is around 20 on a run rate basis. It is ok for a company that has grows revenues at 12% and earnings at 15% - under the current economic conditions.

What can raise the pricing in the stock is the expansion of carriers that carry the iPhone, like adding multiple carriers in the same market. Like adding Verizon, Sprint, T-Mobile in the US. Adding China Mobile in China, etc. As their experience in France has shown, market share can double. The big expansion in the iPod market share too place when Apple went from Mac iTunes to PC iTunes... increased the addressable market.

New products can make a difference. Adding a nice autofocus zoom camera and a decent GPS to the iTouch would help, but I suspect that Apple wants that market left to the iPhone. A well designed Table PC can help too in the educational market.

However, the iPhone is the real killer product... just needs to be turned loose across multiple carriers.

[podlasek]

So does this mean if the rule passes Apple will no longer charge for iPod Touch updates? and misc other firmware updates they have 'had to' charge for in the past due to the accounting?

[GQB]

Originally Posted by podlasek

So does this mean if the rule passes Apple will no longer charge for iPod Touch updates? and misc other firmware updates they have 'had to' charge for in the past due to the accounting?

I'd think the opposite... that they would charge for iPhone updates, since the accrual would no longer be over 2 years... same as for touch.

[OC4Theo]

This is nothing but another accounting game that most publicly traded companies use to mask performance that only benefit them.

Whether the income is reported once or spread over time, what matters is how much cash you deposit in your bank. Cash is king. GAAP or non-GAAP is just nothing but an accounting gimmick!

[Hattig]

Originally Posted by podlasek

So does this mean if the rule passes Apple will no longer charge for iPod Touch updates? and misc other firmware updates they have 'had to' charge for in the past due to the accounting?

That sounds about right to me, as the rule seems to suggest that an appropriate amount is put aside for future upgrade costs in the original purchase price. They could apply this new rule to iPod Touch sales as well (they don't at the moment because it's not a subscription purchase) and thus stop doing silly $5 OS upgrades that probably cost as much to administer as they make.

[Dr Millmoss]

Originally Posted by AjitMD

The market knows what Apple's non-GAAP real earnings are and the stock has priced that in.

You'd think so, since the non-GAAP earnings number is made public by Apple and discussed by at least some of the analysts. The article implies that Apple's earnings would be increased by a change in rules, but this is not the case. What would change potentially is the deferral of earnings. Even as it stands now, all earnings get counted eventually.

Originally Posted by Hattig

That sounds about right to me, as the rule seems to suggest that an appropriate amount is put aside for future upgrade costs in the original purchase price. They could apply this new rule to iPod Touch sales as well (they don't at the moment because it's not a subscription purchase) and thus stop doing silly $5 OS upgrades that probably cost as much to administer as they make.

I'm not so sure. If Apple isn't forced to use the current GAAP methods to report earnings, then presumably they would not be forced to restate earnings from previous quarters if they gave away an update on products where earnings are not deferred.

[rtdunham]

This report comes the same day as news that Apple eliminated one model of its AppleTV and lowered the price on the other, suggesting ATV (or new software) might be imminent. And there's been talk of a new tablet introduction.

Is there any chance apple's waiting for resolution of these accounting procedures before introducing new products that might fall under the old/new regulations while generating big sales? I think the article says presently deferred revenues would all be added at once. But if that's not the case--if there were "old, deferred" revs and "revs booked immediately" for new sales--mightn't a big corporation delay a new product intro, if it didn't want the big product-intro sales blip deferred?

I'm just sayin'...

[Gazoobee]

Originally Posted by GQB

I'd think the opposite... that they would charge for iPhone updates, since the accrual would no longer be over 2 years... same as for touch.

I think it technically would allow them to charge or not charge as they see fit, so all things being equal, they will probably move towards "free."

In the previous scenario, the iPod touch update is charged for only because it's something that has a recorded separate value elsewhere (in the GAAP accounting), isn't it? Seems to me that once that changes, then they could move to either making everyone pay for them or everyone not paying for them. Their choice.

[Bregalad]

Under GAAP revenue is to be recognized when it is earned and corresponding costs incurred. The idea is to match up income and expense the best way possible. If there is an ongoing service obligation then some costs should be recognized throughout that time period and revenue matched to the same time frame.

What I don't know is how AT&T, O2, Rogers, etc. pay Apple for iPhones. Does Apple get all the money up front or are they paid every month for the length of the contract?

I can't imagine Apple wants hundreds of millions in revenue sitting on their books as receivables, particularly if many of those receivables aren't due for 18 months. Normally you reserve receivables for money that's actually due and payable, money you can reasonably expect to receive within 60 days.

[krabbelen]

Originally Posted by OC4Theo

This is nothing but another accounting game that most publicly traded companies use to mask performance that only benefit them.

Whether the income is reported once or spread over time, what matters is how much cash you deposit in your bank. Cash is king. GAAP or non-GAAP is just nothing but an accounting gimmick!

Originally Posted by AjitMD

The market knows what Apple's non-GAAP real earnings are and the stock has priced that in...

You'd think the market knew and figured it in, but I remember an awful lot of articles from a year ago and early this year that were full of confusion -- and how Apple hadn't made that much revenue (maybe a percent or two over GAAP forecast) and therefore they wondered what all the fuss was about from Apple supporters.

The consensus in the tech press and from financial analysts seemed to be, oh well, we don't really get it, we think Apple/Apple supporters are just trying to pull a fast-one and with inflated opinion of the company.

There also seemed to be confusion about the cash: like, "all right, if you really want to look at non-GAAP figures, knock yourself out, but it doesn't mean anything, because if it isn't in Apple's balance sheet for two years, it's because it doesn't exist anyway, so there! Don't try to unfairly count what isn't there.

As I understand it, in actual fact the cash is there. The iPhone is a cash cow. The money is in the bank! Where is that 30billion coming from that keeps mounting? They get what, let's say conservatively, 400 per iPhone from ATT&T. That's up front for the subsidy. Apple is apparently not waiting for product money for two years; if there is an agreement on revenue sharing on the phone contracts, that's over and above base cost of phone.

So, Apple puts down 50 dollars on balance sheet for every phone. But 400 goes in bank. Next quarter 50 more for every phone sold that quarter, PLUS every phone sold the previous EIGHT quarters! If they didn't sell a single iPhone, their balance sheet would still be GROWING for the next two years, because iPhone sales increased over the LAST two years quarter over quarter. AND they would have the interest on all the cash already in the bank.

If the revenue was treated like any regular product from any other company (despite Apple wanting to give away software upgrades), they would instantly show up to eight times the iPhone revenue on their bottom line. Is the current stock price really building that in! And previous quarters would have shown even greater revenue and profit despite the recession.

Then they worry about iPod sales not increasing as much as they have in the past, when there are 20 million Touches out there on iPhone OS 3, which along with iPhones marks a new platform that is still not understood either.

It boggles the mind, why analysts worry about expectations when it comes to Apple. Or why people think this doesn't make a difference to the way Apple's stock has been treated.

[echosonic]

Originally Posted by krabbelen

If the revenue was treated like any regular product from any other company (despite Apple wanting to give away software upgrades), they would instantly show up to eight times the iPhone revenue on their bottom line. Is the current stock price really building that in! And previous quarters would have shown even greater revenue and profit despite the recession.

Then they worry about iPod sales not increasing as much as they have in the past, when there are 20 million Touches out there on iPhone OS 3, which along with iPhones marks a new platform that is still not understood either.

It boggles the mind, why analysts worry about expectations when it comes to Apple. Or why people think this doesn't make a difference to the way Apple's stock has been treated.

Consider also that reporting all the revenue up front means paying all the taxes on PROFITS up front.

Reporting it over time means less immediate tax burden and greater opportunity to earn interest on money in the bank growing steadily from iPhone...and is interest income considered profit, or Capital Gains?

[krabbelen]

Originally Posted by echosonic

Consider also that reporting all the revenue up front means paying all the taxes on PROFITS up front.

Reporting it over time means less immediate tax burden and greater opportunity to earn interest on money in the bank growing steadily from iPhone...and is interest income considered profit, or Capital Gains?

Totally agree. I think that splitting up the revenue was a smart move. It is just that people don't want to see what a strong position Apple is in. Jobs at one point lamented doing it this way, because the stock was being hammered and he wanted to point out the actual situation. And it does seem like Analysts want to be obtuse over it...

I mean, GAAP stands for "Generally accepted accounting principles", and I understand analysts can't advise clients on non-GAAP numbers; but still, it seems like they are not even aware of what the GAAP numbers themselves actually mean! If they want to look at GAAP numbers only, fine. But, the GAAP number (let's conservatively say 50 dollars per iPhone, as 1/8 of 400 total product price), actually means that Apple has ALREADY EARNED 50 dollars per quarter for the next 7 quarters from sale for EVERY iPhone ALREADY SOLD. It's like they totally overlook this. It's like they are saying, "hmmmm, okay, so Apple had revenue of a billion on phones this quarter; wonder what it will be next quarter? Will it be the same, a bit more, a bit less, hmmmm?" Good grief! It might well be about the same without Apple selling a single new phone (Because 8 quarters ago, the totals might be far lower than what they have been more recently). Or, if they only sold the number they sold 2 years ago, then the figures are the same (I think).

So, in terms of what the share price should be, and how widely recognized it is that Apple is in a very strong position, then accounting a diff way could help people see what they should have already seen. But in terms of putting money in the bank, maybe they should keep going as they are, I don't know.

[Dr Millmoss]

Originally Posted by krabbelen

It's like they totally overlook this.

An overstatement. Non-GAAP is not totally overlooked, and probably not even partially overlooked. Apple announces both their GAAP and non-GAAP earnings every quarter now. They are both included in the press releases. I think what is not being understood here is that the non-GAAP earnings don't vanish off the balance sheet, they are just delayed. All of these earnings appear in both forms.

[cameronj]

Originally Posted by Bregalad

Under GAAP revenue is to be recognized when it is earned and corresponding costs incurred. The idea is to match up income and expense the best way possible. If there is an ongoing service obligation then some costs should be recognized throughout that time period and revenue matched to the same time frame.

What I don't know is how AT&T, O2, Rogers, etc. pay Apple for iPhones. Does Apple get all the money up front or are they paid every month for the length of the contract?

I can't imagine Apple wants hundreds of millions in revenue sitting on their books as receivables, particularly if many of those receivables aren't due for 18 months. Normally you reserve receivables for money that's actually due and payable, money you can reasonably expect to receive within 60 days.

No, the phone companies do not pay Apple a little bit every month. Apple gets all the case up front and only recognizes part of it every quarter.

[cameronj]

Originally Posted by krabbelen

You'd think the market knew and figured it in, but I remember an awful lot of articles from a year ago and early this year that were full of confusion -- and how Apple hadn't made that much revenue (maybe a percent or two over GAAP forecast) and therefore they wondered what all the fuss was about from Apple supporters.

An awful lot of articles don't affect the market. It affects individual players, but the smart money (read, the BIG money) knows the real story and will pay what it will pay for earnings.

Originally Posted by krabbelen

There also seemed to be confusion about the cash: like, "all right, if you really want to look at non-GAAP figures, knock yourself out, but it doesn't mean anything, because if it isn't in Apple's balance sheet for two years, it's because it doesn't exist anyway, so there! Don't try to unfairly count what isn't there.

Heh... that's just not the case. There was none of that. First of all, the money IS on the balance sheet. And the people who invest in the 9 figures at a time know exactly what Apple's earnings are.

Originally Posted by krabbelen

As I understand it, in actual fact the cash is there. The iPhone is a cash cow. The money is in the bank! Where is that 30billion coming from that keeps mounting? They get what, let's say conservatively, 400 per iPhone from ATT&T. That's up front for the subsidy. Apple is apparently not waiting for product money for two years; if there is an agreement on revenue sharing on the phone contracts, that's over and above base cost of phone.

There is no revenue sharing.

Originally Posted by krabbelen

So, Apple puts down 50 dollars on balance sheet for every phone. But 400 goes in bank. Next quarter 50 more for every phone sold that quarter, PLUS every phone sold the previous EIGHT quarters! If they didn't sell a single iPhone, their balance sheet would still be GROWING for the next two years, because iPhone sales increased over the LAST two years quarter over quarter. AND they would have the interest on all the cash already in the bank.

Very wrong. But I suppose maybe you're just trying to illustrate what an uninformed investor thinks? Regardless, it doesn't matter what the uninformed investor thinks - it's only a drop in the bucket. All the revenue goes onto the balance sheet the moment it comes to Apple.

Originally Posted by krabbelen

If the revenue was treated like any regular product from any other company (despite Apple wanting to give away software upgrades), they would instantly show up to eight times the iPhone revenue on their bottom line. Is the current stock price really building that in!

Yes

Originally Posted by krabbelen

Then they worry about iPod sales not increasing as much as they have in the past, when there are 20 million Touches out there on iPhone OS 3, which along with iPhones marks a new platform that is still not understood either.

It's understood - there is just a difference of opinion (hello - that's what makes a market)

Originally Posted by krabbelen

It boggles the mind, why analysts worry about expectations when it comes to Apple. Or why people think this doesn't make a difference to the way Apple's stock has been treated.

From the sounds of your post, you are not exactly a seasoned investor, so it shouldn't surprise you that you don't understand why a stock moves the way it does. Just because Apple is your favorite company does not mean that its value is infinite and there can't be reasonable debate about its future prospects. People who have been around much longer than you understand that.

[cameronj]

Originally Posted by krabbelen

I mean, GAAP stands for "Generally accepted accounting principles", and I understand analysts can't advise clients on non-GAAP numbers; but still, it seems like they are not even aware of what the GAAP numbers themselves actually mean! If they want to look at GAAP numbers only, fine. But, the GAAP number (let's conservatively say 50 dollars per iPhone, as 1/8 of 400 total product price), actually means that Apple has ALREADY EARNED 50 dollars per quarter for the next 7 quarters from sale for EVERY iPhone ALREADY SOLD. It's like they totally overlook this. It's like they are saying, "hmmmm, okay, so Apple had revenue of a billion on phones this quarter; wonder what it will be next quarter? Will it be the same, a bit more, a bit less, hmmmm?" Good grief! It might well be about the same without Apple selling a single new phone (Because 8 quarters ago, the totals might be far lower than what they have been more recently). Or, if they only sold the number they sold 2 years ago, then the figures are the same (I think).

Right.

So here you are, at a fork in the road. You have a choice to make. Do you a) assume that the above is true, and these highly paid professionals with millions of dollars at stake are so stupid that an Apple forum poster is running intellectual circles around them, or b) concede that the market knows all the things you do and far more, and is pricing Apple accordingly.

[trragan]

Originally Posted by cameronj

No, the phone companies do not pay Apple a little bit every month. Apple gets all the case up front and only recognizes part of it every quarter.

Right, and this is the basis for accrual basis accounting. The cash payment is made upfront and is deferred as unearned revenue and is recognized ratably.

[krabbelen]

Originally Posted by Dr Millmoss

An overstatement. Non-GAAP is not totally overlooked, and probably not even partially overlooked. Apple announces both their GAAP and non-GAAP earnings every quarter now. They are both included in the press releases. I think what is not being understood here is that the non-GAAP earnings don't vanish off the balance sheet, they are just delayed. All of these earnings appear in both forms.

That is exactly what I was trying to say... it's "like" they overlook it, because the actual meaning does not seem to be fully understood: that the figures are the tip of the iceberg -- they represent the same amount of money ALREADY EARNED for a following seven quarters.

So, yes, obviously, something is not being understood, as I said. They might as well be overlooking it, because they are overlooking something, the implications, or whatever. One implication being that Apple has to sell very few phones to maintain current iPhone income levels (for next two years), and they are soon selling into China to boot.

[krabbelen]

Originally Posted by cameronj

Just because Apple is your favorite company does not mean that its value is infinite and there can't be reasonable debate about its future prospects. People who have been around much longer than you understand that.

I'm not a seasoned investor. The article also addresses the public perception of Apple's strengths and future prospects. It would be nice if there was a reasonable debate on those fronts. Trouble is, it seems to be all about Steve Jobs' health and whether Apple is licensing their software to other hardware developers. The debate never seems to be about the bottom line and Apple's amazing profitability and innovation despite all the pundits saying they should do the exact opposite.

If all the "seasoned" investors are really getting some real analysis behind closed doors despite the public statements of analysts which seem to be largely negative on, yes, largely "overlooked" implications of the facts, then great. Instead seems like a lot of people are selling on wild rumors about Steve's health and other crap, manipulating the price, and contributing to the price fall from 200 to 80 last year.

But those Apple fans who held, and who picked up more at 80 are in good shape. The stock is back up, and some analysts are finally coming around to estimates over 300 and recognizing that Apple is in good shape going forward. Wish I had more money to be that kind of investor. Being an Apple fan doesn't make one a fantasist, just someone who feels there is a little more integrity in Apple and what Apple says than what pundits, analysts and other companies say.

[timgriff84]

Originally Posted by podlasek

So does this mean if the rule passes Apple will no longer charge for iPod Touch updates? and misc other firmware updates they have 'had to' charge for in the past due to the accounting?

Doubt it, they will just need to think of another excuse. There's plenty of examples of companies giving things away for free. In fact Apple gives software away for free that comes on a Mac and as it only runs on a Mac you could deduce its a comparative upgrade. Not to mention there have been software upgrades for normal iPODs that you didn't pay for.

[Dr Millmoss]

Originally Posted by krabbelen

That is exactly what I was trying to say... it's "like" they overlook it, because the actual meaning does not seem to be fully understood: that the figures are the tip of the iceberg -- they represent the same amount of money ALREADY EARNED for a following seven quarters.

So, yes, obviously, something is not being understood, as I said. They might as well be overlooking it, because they are overlooking something, the implications, or whatever. One implication being that Apple has to sell very few phones to maintain current iPhone income levels (for next two years), and they are soon selling into China to boot.

I don't understand what you think is being overlooked, and by whom. Perhaps when Apple first started reporting their income both ways, it caused some confusion amongst those who didn't understand it -- which should not include financial analysts, or investors who pay attention. The other factor to consider is the benefit of reporting income this way. It can smooth over the bumps and valleys in revenue that are caused by product refreshes and seasonal effects. So it's hardly all bad.

Personally, I think this is a teapot storm. If AAPL is being undervalued by investors, it's not because of the way they report income, it's because of concerns over the ability to grow profits in the future at the recent-past rates. In the end, that's what stock values are all about anyway.

[cameronj]

Originally Posted by krabbelen

That is exactly what I was trying to say... it's "like" they overlook it, because the actual meaning does not seem to be fully understood: that the figures are the tip of the iceberg -- they represent the same amount of money ALREADY EARNED for a following seven quarters.

So, yes, obviously, something is not being understood, as I said. They might as well be overlooking it, because they are overlooking something, the implications, or whatever. One implication being that Apple has to sell very few phones to maintain current iPhone income levels (for next two years), and they are soon selling into China to boot.

Yes, and if Apple stops selling iPhones, the stock will tank, because the market is not so stupid to misunderstand the difference between earnings on the income statement and cash coming in.

[cameronj]

Originally Posted by krabbelen

If all the "seasoned" investors are really getting some real analysis behind closed doors despite the public statements of analysts which seem to be largely negative on, yes, largely "overlooked" implications of the facts, then great. Instead seems like a lot of people are selling on wild rumors about Steve's health and other crap, manipulating the price, and contributing to the price fall from 200 to 80 last year.

Your perception of this negative sentiment about Apple is dead wrong. Apple is almost uniformly rated as a buy or a strong buy. Oh and when Apple was going from 200 to 80, I'm trying to remember, wasn't there something else going on in the market at that time too?

Your feelings about Apple are typical of an investor who really doesn't know what he's doing. Take a tip, instead of trying to fight the truth. The market is not out to get you. Analysts cannot affect a stock outside the very short term. The market already knows everything you know. All these things are true, and once you accept them, you'll finally have a chance to understand the market. Until then, you will always think there is a conspiracy out to get you. Don't be that guy.

Originally Posted by krabbelen

But those Apple fans who held, and who picked up more at 80 are in good shape. The stock is back up, and some analysts are finally coming around to estimates over 300 and recognizing that Apple is in good shape going forward. Wish I had more money to be that kind of investor. Being an Apple fan doesn't make one a fantasist, just someone who feels there is a little more integrity in Apple and what Apple says than what pundits, analysts and other companies say.

Being an Apple fan doesn't make you a fanatic, but you are a fanatic about the stock. Tell you what - since you are convinced that it's worth $300 and not $150, why don't you prove it. Show me some numbers that justify that value of the stock.

[cameronj]

Originally Posted by Dr Millmoss

Personally, I think this is a teapot storm. If AAPL is being undervalued by investors, it's not because of the way they report income, it's because of concerns over the ability to grow profits in the future at the recent-past rates. In the end, that's what stock values are all about anyway.

Well stated.