iPhone Accounting Change Could Send Apple Profits And Stock To Moon

Apple accounts for many iPhone sales by spreading the revenue over two years on the theory that the phone is subsidized in exchange for a two-year contract because Apple provides free software updates over the life of the phone.*

At the same time, however, Apple gets all the iPhone cash upfront, which has produced extraordinary cash flow relative to reported earnings in recent years.

The full power of the iPhone’s success has long been visible to anyone who has looked at the company’s cash flow statement.  In recent quarters, Apple has also begun publishing “non-GAAP” earnings that show what their reported EPS would have been had they accounted for the phones in a more typical way.  The company’s GAAP earnings, however, have never fully reflected the awesome profitability of the iPhone.

But that may soon change. 

In a report last week, Credit Suisse describes an accounting rule change that may eventually allow Apple to book most iPhone revenue upfront.  Doing so would not change the company’s cash flow, so there would be no actual change in the theoretical value of the company or stock.

But the change would cause Wall Street analysts to jack up their earnings estimates, and it would significantly boost the company’s reported earnings.  This would make Apple’s stock look much cheaper to unsophisticated investors.  It might also, therefore, act as a catalyst for the stock.

(Silly?  Yes.  But stranger things have happened.  Perception is reality…).

Credit Suisse analyst Bill Shope:

We have learned from our conversations with Credit Suisse’s Accounting and Tax
Research team (led by David Zion) that in a meeting yesterday, the EITF approved a
change to the rule that requires Apple to recognise the iPhone on a ratable basis (SOP 97-
2). While it’s a draft rule at this point, it should receive final approval in the next several
weeks. The following key takeaways are important for hardware investors:

The rule change. SOP 97-2 is the accounting standard that requires Apple to
recognise iPhone revenues and profits over a 24-month period. The basic concept is
that because Apple offers free software updates on the device, it has to recognise the
revenues and costs over the life of the hardware. After intense lobbying by several
technology companies, however, FASB agreed to review the rule. The EITF
(Emerging Issues Task Force), which is part of FASB, effectively reversed the rule in a
meeting yesterday. At this point the new rule is a draft rule, but it should receive final
approval in the next few weeks. The new rule will allow Apple to recognise the iPhone
hardware revenue and profit at the point of sale, while an estimated value for the
software will be recognised over the life of the device. 

This impacts the iPhone and Apple TV businesses. While the ratable accounting
for the iPhone is the primary focus for investors, this accounting rule was also applied
to the Apple TV business. 

* The difference in revenues and profits is substantial. Last quarter, Apple’s non-
GAAP (non-ratable) revenues were 16.9% higher than GAAP, while non-GAAP EPS
was 58% higher. For all of fiscal 2009, the differences are 16.3% and 48.5%,

* There will still be some accounting puzzles to solve. The new rule proposes that
all future sales of products are impacted, but prior sales are not affected. In addition,
Apple will have to estimate the value of iPhone software updates, which is not easy for
investors to forecast.

* GAAP EPS may actually be higher than our current non-GAAP. Interestingly, by
recognising historical iPhone sales on a deferred basis and new iPhone sales on a
period basis, Apple’s GAAP results under the new rule will now be inflated (they would
get credit for current iPhones AND devices sold over the prior two years). As a result,
we suspect pro-forma estimates will still be necessary. Either way, the artificial
compression of GAAP earnings will no longer be an issue under the new rule. 

* It may take a while for Apple to implement. The new rule would not be mandatory
until Apple’s fiscal year 2011, but we suspect the company will choose to implement it
much earlier. Nevertheless, revenue and profit recognition changes can require
complex enterprise software and accounting overhauls, so this may take the company
a few quarters.
* In the end, true earnings power should be more apparent. Although Apple already
reports non-GAAP revenues and earnings, consensus and management guidance is
still GAAP. This new rule would change that, and it should make Apple’s true cash
earnings power more apparent to a broader base of investors.

Overall, while this does not change the cash dynamics at Apple, we believe the rule
change will make it easier for investors to understand the massive cash earnings power of
the iPhone. We believe this is a clear positive catalyst for Apple’s stock. 

* Our Apple analyst, Dan Frommer, notes below that I was wrong about the reason Apple is currently recognising iPhone revenue and costs over two years.  I’ve corrected the error above.  Here’s Apple’s explanation from a transcript at Seeking Alpha:

As we have discussed in the past, because we may provide new features and software applications to iPhone and Apple TV customers in the future free of charge, in accordance with GAAP we use subscription accounting to recognise revenue and cost of sales for these products on a straight line basis over their two-year estimated economic lives. This results in the deferral of almost all revenue and cost of sales related to iPhone and Apple TV during the quarter in which these products are sold to customers.

In contrast, we generally recognise revenue and cost of sales for our other hardware products, such as Macs and iPods, at the time of sales as we do not provide new features or software applications for those products free of charge.

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