Enroll in apple iphone upgrade program

Accounting For The IPhone Upgrade Program Case Writeup

1) Why do you think Apple introduced the iPhone Upgrade Program? What value might Apple be adding from a customer’s perspective?

2) How do you think the Upgrade Program will affect how revenue is recognized at Apple compared to iPhones sold outside of this program? How would the change affect the income statement and balance sheet? In answering this question, focus on case Exhibits 3, 5, and 6.

JONAS HEESE KRISHNA G. PALEPU H. PAVID SHERMAN MONICA BARALDI

A c c o u n t i n g f o r t h e i P h o n e U p g r a d e P r o g r a m ( A )

The iPhone has become one of the most important, world-changing and successful products in history. Last week [July 27, 2016] we passed another major milestone when we sold the billionth iPhone. We never set out to make the most, but we've always set out to make the best products that make a difference.

- Tim Cook, Apple CEO1

I n t r o d u c t i o n

On September 9, 2015, Apple Inc. (Apple) launched its new iPhone 6s and iPhone 6s Plus models and, at the same time, announced the "iPhone Upgrade Program," a new way to purchase those iPhone models in Apple's retail stores throughout the U.S.2 Under the program, eligible consumers could buy an iPhone 6s and 6s Plus and, as a form of payment, agree to a 24-month loan in partnership with Citizens Bank (Citizens).3 An iPhone purchased under the program was unlocked, meaning customers were able to switch their wireless carrier according to their contract terms. The offer included Apple's AppIeCare+ service, which provided extended warranty and software support compared to the regular one-year limited warranty. After one year the iPhone customer could turn in her old iPhone, get a new iPhone model, and enter into a new installment loan agreement, with a new two-year payment obligation.4 In the event the iPhone upgrade program was terminated by the customer, the customer was responsible for any outstanding balances due under the terms of the loan with Citizens.5

Following the announcement, several financial analysts reacted positively to the new upgrade program; some of them described it as a "smart move" forward.6 According to one UBS analyst, the "Upgrade Program increases stickiness and makes the iPhone look more like an annuity business."7

Another J.P. Morgan analyst estimated that Apple's margin for an iPhone sold under the new program could be four times higher than that for iPhones sold through the carrier channel, as Apple was charging $50 more per device under this program.8 A UBS analyst wrote that the iPhone Upgrade Program "could be a big deal," as it allowed Apple to take control of the customer relationship.9 One observer predicted that 75% of Apple's iPhone customers would eventually switch to an annual upgrade, increasing Apple's U.S. iPhone unit sales by 10% over three years.10

HBS Professors Jonas Heese and Krishna G. Palepu, Professor H. David Sherman (Northeastern University), and Case Researcher Monica Baraldi (Case Research & Writing Group) prepared this case. This case was developed from published sources. Funding for the development of this case was provided by Harvard Business School and not by the company. HBS cases are developed solely as the basis for class discussion. Cases are not Intended to serve as endorsements, sources of primary data, or illustrations of effective or Ineffective management.

Copyright © 2016 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to www Jibsp.harvard.edu. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.

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117-020 Accounting for the iPhone Upgrade Program (A)

Other business analysts were more skeptical about the program, as it came with risks related to competition from wireless carriers. Because carriers made money when phone users paid them for service, and because phone users tended to stick with a single carrier long-term, carriers had an incentive to try to lock in customers by selling them phones that came with a two-year contract They could do this by offering other brands of phones at lower prices than Apple.11 "Apple's move is perhaps a bit threatening, in mat it incrementally erodes the carrier's relationship with the customer," said one senior analyst.12

Next to the strategic implications of the Upgrade Program, analysts tried to understand the accounting implications, especially for recognition of revenue, which the Upgrade Program could have on Apple's financials. Some assumed "no dramatic change" in revenue recognition, while others were waiting for more guidance from Apple.

In an effort to increase iPhone sales, Apple was pushing the Upgrade Program hard for the 2015 holidays in its retail stores, on its website, and in unsolicited e-mails.13

C o m p a n y B a c k g r o u n d

The iPhone went on sale for the first time at the end of June 2007 and, at a starting price of $500, was immediately criticized by bloggers and news commentators for being too expensive compared to an average smartphone priced roughly around $200.M The doubts were soon dispelled. By the end of 2007, Apple sold two million iPhones, and almost seven million in the last quarter of fiscal year 2008.15 Front a strategic perspective, between 2007 and 2014 Apple had been "remarkably consistent"16 in maintaining a smartphone price somewhere near $700 and annually launching anticipated handsets which featured incremental or radical innovations.17 Apple typically releas_e3^ewTPhqne models in the fall, increasing Appkys~sma~rtphone.units-spld and boosting revenue during the first quarter of the

-fiscal year, which typically started on 6ctober-l .18 ^

In 2015, Apple faced a challenging and changing competitive environment. The major wireless service providers such as AT&T, Sprint, T-Mobile, and Verizon were competing for subscribers in a mature U.S. market.19 Most consumers already had a cell phone and switched carriers infrequently. The average phone upgrade frequency in the U.S. had risen from 18 months in 2010 to an estimated 26 months in 2015.20 The average contract between the consumer and the wireless carrier stretched across two years in which the customer had to sign an agreement with the carrier and pay early-termination fees "in exchange for a discounted price on a phone."21 However, new trends were emerging.

In the summer of 2015, two-year contracts were disappearing,22 unlocked phones were becoming more popular, and consumers were accepting the idea of paying the full cost of a phone upfront in exchange for the freedom to select their preferred carrier at any time.23 By 2013, T-Mobile was the first carrier that no longer sold two-year contracts. "Once T-Mobile did it, all the others followed,"24 said an industry insider. Furthermore, new players were entering the mobile market. Google was testing a wireless service, Google Fi, which would allow consumers to switch from T-Mobile to Sprint and back multiple times.25

Apple's management decided that it was time to innovate the iPhone business model. In September 2015, the company announced the new iPhone Upgrade Program. For the first time, Apple financed iPhone sales directly to customers without locking them to any particular carrier.26

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i P h o n e U p g r a d e P r o g r a m

Under the new iPhone Upgrade Program, available only through Apple's retail stores in the U.S., the company began offering a 24-month payment plan for the unlocked iPhones 6s and 6s Plus and the AppleCare+ service for $32.41 and $44.92 a month, respectively. Customers could upgrade to a new device after making 12 payments and could switch to new service carriers according to the contractual terms. (See Exhibit 1 for the iPhone Upgrade Program terms and conditions.)

From a consumer perspective, the new program did not provide any savings on the device. The final payment would end up being about $778 for the iPhone 6s, which reflected the combined standalone prices of the iPhone 6s ($649) and the AppleCare+ coverage ($129). However, as Apple typically did not increase the price of its new iPhone models, the upgrade program made it attractive for customers to upgrade. One expert reported that "[t]he leasing program" may seem like Apple is doing consumers a favor, but if s really an effort to ensure people buy new phones or continue paying more for the old one if they decide to hold on to it."27 One consumer columnist wrote: "It [the iPhone Upgrade Program] is a decent deal if you're one who simply must upgrade to the latest, greatest gadget as soon as it comes out. But if you're like me and you keep your phones for years, then you're probably better off buying instead of [essentially] leasing."28

Product innovation at Apple had anticipated the company's new strategy in the mobile business segment. A multi-carrier SIMb enabled the new iPhones 6s and 6s Plus to run on any wireless network in the world. This innovation would allow consumers to move between cellular carriers according to their preference.29 One respected Silicon Valley inventor said of Tim Cook and Apple: "They've opened up tiie floodgates. The strongest tie that an operator has to a user is a financial one, where there's either a pre-paid plan or an installment plan. With this new Apple [multi-carrier SIM], that goes away."30

From a strategic perspective, the new_iPhone Upgrade Program opened several possibilities for Apple's iPhone business. First, customers were allowed to access high-end handsets with a limited upfront payment. The program encouraged a higher turnover of the phone, at a time when the average iPhone replacement cycle was longer than two years.31 Second, sales of iPhone units had slowed in 2014 and 2015, and observers noticed that sales of services, such as Internet services, AppleCare, and Apple Pay, were becoming more and more relevant.32 With reference to the^6«rvices" business segment, Cook said: "The growth was broad-based, with APP Store revenue urxS7% to a new all-time high, hi addition to-a .strongjincrease in Apple Music, iCloud, andAppleCare.^-^See fcxmbIT2Frbr~~

.-Apple's revenue and units sold by product.) _ ""

The program also allowed Apple to enter the market for used iPhones, especially in developing countries where new iPhone models had significantly lower customer penetration. One AT&T senior executive said, "If they [Apple] are successful there will be a lot of slightly used pre-owned iPhones or handsets out there. We'll be really interested in talking to them about partnering with them to utilize those [used iPhones]."34 Financial analysts were forecasting profitable market opportunities. Gartner estimated that the high-end second-hand smartphone market would reach $14 billion by 2017,35 but for analysts it was difficult to find "meaningful data to support an estimate," as one observer wrote.36

a Under the Upgrade Program, consumers purchased and owned the phone. However, due to the payment plan structure of the accompanying loan and the ability for a consumer to turn in their phone early, some analysts referred to the program as a leasing program. b Most mobile devices contained SIM cards, or subscriber identity module cards. These were removable smart cards that stored a mobile device's identifying features, technological elements enabling voice encryption, and the user's contacts and message data. They enabled the device to connect to a specified carrier's cellular network.

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A UBS analyst reported, "Our best guess for iPhone users who are using a second-hand iPhone is somewhere around 35 million to 45 million or roughly 10% of the user base, growing by 5 to 7 million each quarter prior to the launch of the iPhone 6s and 6s Plus. With an increasing supply of iPhones traded-in within 1-2 years, we believe the available stock of used iPhones will rise."37

In India, where Apple had a 2% market share, 70% of smartphones sold for less than $150. In 2016, in an effort to increase its sales, Apple was seeking permission from government officials to sell pre- owned iPhones in India. Above all, Apple saw growth potential in China's rising middle class. Chinese customers still viewed the iPhone as a luxury product. However, Apple faced strong competition in China, especially from Xiaomi and Huawei. In 2015, Xiaomi, a Chinese company headquartered in Beijing, grew at a 23% annual rate. Its management had projected 100 million smartphone shipments for that year.38 Xiaomi controlled 15.8% of the smartphone market, followed by Huawei (15.4%) and Apple (12.2%)39 The Chinese market was especially resistant to the introduction of iPhone 6 models since, according to a 2014 market analysis, smartphones from national brands had a competitive price and were perceived as having good quality.40

Finally, the iPhone Upgrade Program created new alliances. It redefined commercial and competitive terms with phone carriers such as AT&T, T-Mobile, and Verizon. A former Verizon senior executive said: "Apple's move is a sign it wants to wrest control of customers from wireless carriers. Companies that control the customer relationship have more leverage in pricing and sales."41 A top manager at Sprint stated, "Apple is trying to do nothing more than shorten the cycle so they can sell more iPhones."42 A T-Mobile senior executive was supportive of Apple's new strategy, saying "it would allow customers to try out other carriers."43

The Upgrade Program relied on a partnership with Citizens Bank. Citizens was a subsidiary of Citizens Financial Group, one of the oldest financial institutions in the U.S., headquartered in Providence, Rhode Island.44 Citizens provided the two-year installment loan for consumers who paid a monthly amount tied to a credit card for the purchased iPhone. When the plan was launched. Citizens was Apple's only financial partner.45 One observer noticed that, for several years, Citizens had offered loans for college students and teachers to purchase Apple products. Some saw Citizens' collaboration with Apple as a low risk partnership for the bank, which controlled the credit risk related to the contract, decided on eligibility for each Apple customer applying to the Upgrade Program, and likely received interest payments from Apple to grant Apple's customers 0% loans.0 At the end of 2015, Citizens added $220 million in loans to its balance sheet, which, according to one analyst, accounted for 250,000 iPhone 6s sales in Apple Stores.46

i P h o n e R e v e n u e R e c o g n i t i o n

The revenue recognition for Apple's iPhone had undergone several changes over the years. Before fiscal year 2010, Apple reported revenues from its iPhone sales using the subscription method of accounting.47 iPhone products fell under the software revenue recognition rules pursuant to American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) No. 97-2.48 Apple used subscription accounting as it periodically provided new software updates to iPhone customers free of charge, making the iPhone a product "in which the hardware and the operating system software were tightly bundled."49 SOP 97-2 required companies to use subscription accounting for such software-

c One analyst believed that "Apple is effectively paying an interest rate in the realm of 6-12% annualized." Gene Munster, "Thoughts on iPhone Upgrade Plan Economics and iPhone User Survey," Piper Jaffray, November 23,2015, via Thomson ONE, accessed November 2016.

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enabled hardware devices. Under subscription accounting, Apple recognized the revenue and cost of goods sold for the iPhone on a straight-line basis over the product's estimated 24-month economic life. Thus, Apple's quarterly revenues reflected only one-eighth of the total revenue from iPhone sales during that quarter. This resulted in a deferral of the remaining revenue and cost of goods sold, although the company received and reported the related cash flow in the fiscal quarter when the sale happened. As long as iPhone sales increased each quarter, the deferral balance followed the same trend. (See Exhibit 3 for an illustration of the iPhone subscription accounting.) By the fourth quarter of 2008, Apple's deferred revenues reached $7.8 billion, at which point Apple decided to provide additional information to analysts and investors that gave Apple's watchers a look at Apple's revenue numbers without the use of subscription accounting.50 (See Exhibit 4 on Apple's deferred revenue.)

In 2009, the Financial Accounting Standards Board (FASB) ratified Emerging Issues Task Force (ErTF) Issue No. 09-351 ("2009 rule"),d which Apple immediately supported and adopted in the first quarter of fiscal year 2010.52 The "2009 rule" allowed Apple to split multi-element arrangements, such as the iPhone, into separate deliverables. In the case of the iPhone the first deliverable was the hardware and software "essential to the functionality of the hardware device at the time of sale;"53 the second deliverable was related to the right to receive "future unspecified software upgrades and features relating to the product's essential software."54 Following the "2009 rule," Apple was able to recognize the iPhone hardware revenue as soon as the iPhone was sold, while the revenue recognition for the frequently updated software was based on an estimated value to be recognized over the life of the iPhone, similar to using subscription accounting. (See Exhibit 5 for an illustration of the iPhone accounting under the "2009 rule.")

In May 2014, the FASB issued the Accounting Standards Update (ASU) No. 14-09, Revenue from Contracts with Customers, which amended the existing accounting standards for revenue recognition.55 ASU 14-09 aimed to provide a comprehensive and uniform framework for revenue recognition across entities and industries, thus replacing special rules such as EITF 09-3. Similar to the "2009 rule," the core principle of ASU 14-09 was to identify separate deliverables (referred to as performance obligations under the new standard) and their respective transaction prices. Revenue was recognized when a performance obligation was satisfied. Apple was considering adopting the standard in either its first quarter of 2018 or 2019.56

Beginning in September 2015, Apple estimated the revenue allocated to the software deliverable to be about $10 to reflect the increase in competitive offers for similar products at little to no cost for users. This reduced the amount Apple could reasonably charge for these deliverables on a standalone basis. Thus, when selling an iPhone, Apple only deferred up to $1? for the software component.57

iPhone Revenue Recognition under the Upgrade Program

The iPhone Upgrade Program introduced additional accounting complexities. Next to the handset and the software, the Upgrade Program also required the customer to subscribe for AppleCare+ and gave the customer the right to trade in her used phone.58 Upon exercise of the trade-in right and purchase of a new iPhone, the customer enrolled in a new two-year 0% loan with Citizens, Apple satisfied the customer's outstanding balance due to Citizens on the original device, and Apple paid interest to Citizens for granting the new loan.

" The title "2009 rule" is not an official term. The case authors use the expression "2009 rule" only to improve clarity and comprehension of the case narrative.

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The revenue from AppleCare+ was deferred and recognized ratably over the service coverage period of two year. In presenting the Q4 2015 financials, Apple CFO Luca Maestri explained that Apple would be "deferring the portion of revenue related to AppleCare+."59

Apple accounted for the trade-in right as a guarantee liability and recognized revenue for the iPhone net of the value of such right. According to an accounting experts, trade-in rights were typically treated like a right to return the purchased item. To determine the value of this right (and consequently the guarantee liability), Apple had to estimate the number of customers exercising the right and the point in time customers exercised the right. The difference between the sales price and the expected value of the trade-in right is the revenue that should be recognized at the time of sale, whereas the expected value of the trade-in right is recorded as a guarantee liability on Apple's books. Recognizing such liability resulted in a deferral of the remaining revenue and cost of goods sold, although Apple received and reported the full cash from the sale of the phone from Citizens in the fiscal quarter when the sale happened. The more iPhones sold under the program and the earlier customers exercised the trade-in right, the larger the guarantee liability, and consequently the less revenue could be recognized at the time of sale. The deferred part of cost of goods sold represents the expected value of the returned phone and is recorded as a Right of Return Asset on the firm's balance sheet (See Exhibit 6 for an illustration of the iPhone accounting under the new Upgrade Program and Exhibit 7 for Apple's revenue recognition policies.)

At the end of each financial reporting period, the estimate of the firm's return expectations were updated. Changes in this estimate were accounted for as adjustments to the amount of revenue and cost of goods sold recognized. In 2015, Apple described in its 10-K that it recognized subsequent changes to the guarantee liability within revenue.60

The Upgrade Program carried three additional issues that were not directly related to revenue recognition but nonetheless impacted Apple's financials: the value of a right of return asset, refurbishment costs, and inventory impairments of refurbished phones.

Value of Right of Return Asset Apple promised its customers to take back the used iPhones and pay the outstanding balance due to Citizens if certain conditions were met. If, at the time of sale, the company expected that the outstanding balance was larger than the value of the returned phone, the company would adjust the right of return asset as well as costs of goods sold accordingly. (See Exhibit 8 for market prices of used and refurbished iPhones). In addition, Apple had to periodically check if the carrying amount of the right of return asset was still recoverable. If Apple determined that the fair value of the used iPhones decreased, it recorded an impairment loss equal to the amount by which the book value of its iPhones exceeded the fair value (net realizable value) of these iPhones.