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FASB approves proposed accounting rule change

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By Charles Starrett

Contributing Editor
Published: Thursday, September 24, 2009
News Categories: iPhone

The United States Financial Accounting Standards Board has approved an accounting rule change that will allow Apple to abandon its practice of subscription accounting for the iPhone. Currently, Apple defers its iPhone revenue over two years to allow for free software updates to be delivered over the life of the cellular contract, and does the same for Apple TV; the new rule would allow the company to recognize more, if not all, of that revenue up front. Apple, along with several other tech companies, had lobbied the FASB in favor of the rule change as more devices become dependent on software for their core functionality, such as the iPod touch, which up until now has seen each major update come at a cost due to the different methods used to account for its revenue. Most companies are expected to adopt the rule beginning in 2011; it is unclear whether Apple plans on making the switch at the start of its 2011 fiscal year, which begins on September 27.

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Comments

1

Does this mean that we’ll have to start paying for iPhone software upgrades, too, like the iPod Touch upgrades? Or will the Touch upgrades now be free?

Posted by JonS on September 24, 2009 at 10:18 AM (PDT)

2

iPhone upgrades should remain free, Apple’s clearly considered them the cost of promoting the iPhone.

What the rules change is that if a company considers software updates as adding value to the initial product and they aren’t charging money, then the notion was that the product was shipped in an unfinished state, and it’s illegal to report full revenue from an unfinished product or job. To avoid having the iPod touch and the iPhone being considered technically unfinished, Apple could have done one of two things: simply declared software updates weren’t adding value to the initial product, this is what most hardware makers have been doing for ages, the “hey, maybe a driver update comes out that adds features, maybe one doesn’t, oh well” approach. Or they could have essentially escrowed some percentage of the initial sale revenue and only reported it when major iPhone OS updates were released. Apple took the third option: declared that, yes, the iPhone OS updates do add value to the initial product and we’re going to charge for each major update. For the iPhone, the fees were deducted from the subscriber fees paid indirectly to Apple, touch users just got charged.

With the change in the rules, now Apple loses their excuse as to why they had to charge for the touch updates, but what they will do is anybody’s guess. They no longer *have* to charge even if they consider them as adding value, but the law clearly doesn’t prevent them from charging. We’ll see what Apple does with the change in rules.

Posted by Code Monkey in Midstate New York on September 24, 2009 at 4:55 PM (PDT)

3

IIUC, Previously Apple couldn’t allocate funds to maintaining software for out-of-warranty hardware. That is why new iPods are released each year and firmware updates for old iPods stop almost immediately. iPhone OS updates are subsidised by Revenue sharing with AT&T.

iPod Touch updates are complicated. They share the OS with the iPhone, but don’t have a software revenue stream. That is why users are charged for major iPod Touch updates.

Major Mac OS X updates are also pay-for, to offset development costs. I don’t know how the Major AppleTV updates are Accounted for. Maybe that is why it’s classed as a “Hobby” product.

Posted by Dan Woods on September 24, 2009 at 4:57 PM (PDT)

4

@3: That’s merely another facet of Apple incorrectly wielding the SOX Act to its advantage. Just this morning I downloaded and installed drivers & software - from Jul 2009 - that increase the performance of a video card I purchased in mid 2005. “Amazingly”, I was not charged for this update, nor any of the previous three times I’ve updated the software and drivers for this particular video card.

The issue is if the company wants to claim the software updates are part of the value of the initial hardware product. Here’s examples of the type of situations the SOX Act is meant to cover:

Example 1 - Corporation A ships an office product that is supposed to be an all in one fax, copier, scanner, and printer. At the time the product hits the shelves, faxing is not possible because some last minute glitch in the software was discovered. Corporation A has already promised that this product will be able to fax and they fully intend to deliver on that promise within the next 90 days of the product’s release. Since the product is unfinished, Corporation A must withhold reporting a certain percentage of their revenue from the product’s sales until they deliver the software update that allows it to fax.

Example 2 - Corporation B sells a music player that comes with one year of free software updates, software that they charge out of warranty models for. In that case, those software updates are part of the value of the initial hardware sale so they must withhold reporting some amount of the initial sales revenue until the software updates have been delivered.

At no point have these accounting laws prevented companies from releasing software updates for free for any product. It is only a matter of if the company explicitly markets the products with such updates as part of their promised value and those updates have a definable value. Most companies simply never charge for the updates, ergo, they have no value, and there’s no explicit promise that there will be future updates and/or new features from software so the value for the hardware sale is for it “as is”.

Apple’s practices have almost never intersected with the SOX Act. The only case I can think of where Apple’s practices truly fall under these accounting laws is when they ship a new computer model near the time of a new version of OSX and explicitly state you will be able to upgrade to that new version for free whereas everyone else must pay. In the case of the touch and iPhone, they’ve simply been trying to play it both ways: declaring the updates have a retail value, proving that by charging touch owners to upgrade, and still avoiding having to withhold initial revenue for the updates by filing that the iPhone users’ update fees will be derived from the indirect subscriber fees paid to Apple.

Since Apple never actually had their hands tied by the rules to begin with, what effect the change will have for consumers is unknown. In truth, it could just be a bonus to Apple with no change to their practices: Apple could continue to charge touch owners upgrade fees, continue to keep iPhone updates free, and now report 100% of the subcriber fee payments as unallocated revenue giving the appearance of slightly better revenue from the iPhone, and yet nothing will have changed on Apple’s bottom line.

I spent two years of my life working as an accounting clerk for a defense contractor. These rules exist for no other purpose than to confuse, it’s just a question of who they are trying to confuse more.

Posted by Code Monkey in Midstate New York on September 25, 2009 at 6:04 AM (PDT)

5

It’s also worth pointing out that Apple never actually said that they had to charge for software updates due to any kind of accounting regulation.  A couple of years back, when they charged a nominal $5 fee to provide the 802.11n upgrade to older MacBooks, they made it very clear that it was SOX and FASB rules that required them to do this. Further, in that particularly case it made some sense, as the MacBook essentially shipped with a technology that was not enabled until later.

On the other hand, Apple themselves never provided this as the reason for the iPod touch upgrades. The reason for the charge being based on accounting rules was speculation offered by third-party Apple apologists to try to justify why Apple was doing this.

So in other words, I’m not holding my breath that Apple is going to change their policies of charging for iPod touch updates just because these rules have changed.  Further, even if this is a catalyst for that policy changing, the new rules don’t come into effect until 2011, so don’t expect iPhone OS 4.0 to necessary be a free upgrade for iPod touch users.

Posted by Jesse Hollington in Toronto on September 25, 2009 at 11:05 AM (PDT)

6

Agreed, Apple never explicitly said they had to charge for touch updates because of SOX (which would be a lie if they did), but since they do charge touch owners, SOX was undeniably “messing up” their accounting with the iPhone, hence this joining on the bandwagon for change. I doubt they’ll stop charging either for exactly the scenario I outlined above. This is all about them showing greater POS revenue for the iPhone and Apple TV.

Although, I’ll also point out that the $5 802.11n upgrade excuse was a lie, or if not a lie, indicative of their sometimes deceitful sales practices. The only way SOX should have played any role is if they had promised it would gain 802.11n and that it was not included in the purchase price, ergo they were free to report the full revenue up front. Since Apple never made any such promise when the products launched, the only way SOX would have forced them to collect a fee was if internal Apple documents proved Apple planned all along to activate the 802.11n at a future date for later buyers as a product enhancement (which, having watched Apple over the years, was probably the case).

The apologists seem to think SOX has some mythical ability to prevent manufacturers from adding features via software or firmware updates at a future date for free, and that’s simply not the case. The only purpose of SOX was to force manufacturers to be more honest in their revenue reporting: if the sale of a product is necessarily and inextricably tied to future features or support, then break out what percent of the sale is derived from those future features or support and defer reporting it as revenue until such time as they are delivered. That’s it. It was a pretty simple act that unfortunately just became an excuse for “toll booth” business practices from companies unwilling to account honestly for fear their investors would be scared off by the short term single digit percent decrease in POS revenue that would have shown up on a later accounting sheet anyhow.

Posted by Code Monkey in Midstate New York on September 25, 2009 at 12:05 PM (PDT)

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