Iphone revenue recognition

Professors Francois Brochet and Krishna G. Palepu and Research Associate Lauren Barley prepared this case. This case was developed from published sources. 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 © 2011, 2013 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.hbsp.harvard.edu/educators. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.

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Accounting for the iPhone at Apple Inc.

On October 21, 2008, Apple Inc. announced financial results for Q4 of FY 2008 ended September 27, 2008 (see Exhibit 1). Under the U.S. generally accepted accounting principles (GAAP), Apple reported quarterly revenue of $7.9 billion and net profit of $1.1 billion. For the first time, the Cupertino, California-based company included non-GAAP measures in its earnings announcement to supplement its U.S. GAAP financial results. Apple’s non-GAAP quarterly revenue and net profit were $11.7 billion and $2.4 billion, respectively. As Apple CEO Steve Jobs noted, “As you can see, the non-GAAP financial results are truly stunning.”1 He explained the change in a rare appearance on the company’s earnings conference call later that day:

I would like to . . . talk about the non-GAAP financial results, because I think this is a pretty big deal. In addition to reporting an outstanding quarter, today we are also introducing non- GAAP financial results, which eliminate the impact of subscription accounting. Because by its nature subscription accounting spreads the impact of iPhone’s contribution to Apple’s overall sales, gross margin, and net income over two years, it can make it more difficult for the average Apple manager or the average investor to evaluate the company’s overall performance. As long as our iPhone business was small relative to our Mac and music businesses, this didn’t really matter much, but the past quarter, as you heard, our iPhone business has grown to about $4.6 billion, or 39% of Apple’s total business, clearly too big for Apple management or investors to ignore.2

Jobs also noted that in terms of non-GAAP mobile-phone revenue, in just 15 months Apple had become the world’s third-largest phone manufacturer behind Nokia and Samsung but ahead of Sony Ericsson, LG, Motorola, and RIM.

Company Background

Jobs and Steve Wozniak launched the personal computer revolution in the 1970s with the Apple II. In 1984, the Apple Macintosh, with its ease-of-use and brilliant design, redefined the personal computer. Shortly thereafter, Jobs left the company, returning in 1997. Under Jobs, Apple catalyzed the digital-media industry with the launch of its iPod portable musical player in October 2001, followed by the introduction of its iTunes online store in April 2003.

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111-003 Accounting for the iPhone at Apple Inc.

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In June 2007, the company entered the highly competitive mobile-phone market with its iPhone, the first smartphone (a combination of a phone and a mini-computer) with a touch-screen interface and the company’s new mobile operating system, iOS. Several months later, Apple released the iPod touch (an iPhone without the phone capability).

Apple released its iPhone 3G in July 2008 along with its second-generation mobile operating system (iOS 2). Also in July 2008, Apple introduced its App Store, which offered iPhone and iPod touch users a wide variety of mobile applications ranging from games to social networking to productivity tools, mostly priced under $10. On July 14, 2008, Jobs noted, “The App Store is a grand slam, with a staggering 10 million applications downloaded in just three days. Developers have created some extraordinary applications, and the App Store can wirelessly deliver them to every iPhone and iPod touch user instantly.”3 Many of the applications took advantage of the more robust iOS 2. By October 2008, Apple was best known for its technical and design innovation, its “walled garden” approach (i.e., its mostly proprietary ecosystem of hardware, operating and application software, and peripherals), and its premium-priced products.

iPhone Business Model

The original iPhone 8GB model had a U.S. retail price of $399 and was available through Apple and AT&T, the iPhone’s exclusive U.S. mobile carrier. In the U.S., mobile carriers typically provided subsidies to phone manufacturers, which lowered the purchase price of the new phone. In exchange, most consumers signed a two-year service contract with the carriers. Apple and AT&T agreed to a different arrangement, but did not disclose its specifics. AT&T did not subsidize the iPhone; instead, Apple signed a revenue-sharing agreement with AT&T that gave Apple a share of the subscribers’ monthly service fees. Needham & Co. analyst Charles Wolf believed that AT&T paid Apple $10 per month over a typical two-year contract.4 In addition, although Apple did not disclose how much it sold the iPhone for to AT&T, analysts believed that Apple made an estimated $120 in gross profit on every iPhone sold.5

At the iPhone’s launch, Apple announced it might periodically offer new software updates and upgrades free of charge to its iPhone customers. In contrast, Mac and iPod users did not receive free software features and upgrades. For example, users were charged $129 to upgrade to the new Mac operating system (Mac OS X Leopard) in October 2007, whereas Apple planned to provide newer versions of the iPhone operating system free of charge to all iPhone users. Apple’s chief financial officer Peter Oppenheimer explained, “Since iPhone customers will likely be our best advocates for the product, we want to get them many of these new features and applications at no additional charge as they become available.”6

In addition, Apple’s management knew that smartphone users were slow to update their software, and that few opted to buy upgrades. Therefore, the company believed it was necessary to offer new software features free of charge to increase user acceptance. In contrast, most other mobile software vendors reserved new software updates for new hardware (i.e., phone) releases.7 Apple, AT&T, third-party application developers, and users would all benefit from consumers’ use of the latest operating system and applications, giving Apple and its ecosystem a competitive advantage. AT&T would run a more effective and efficient mobile network; third-party software developers would have a stable hardware and software roadmap; Apple could delist applications from its App Store that weren’t written for its latest operating system; and all the while, iPhone users would benefit from an evolving and differentiated set of features and functionality. Many users of Do

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This document is authorized for educator review use only by Abirami Devi Sivakumar, Jubail University College until December 2016. Copying or posting is an infringement of copyright. Permissions@hbsp.harvard.edu or 617.783.7860

Accounting for the iPhone at Apple Inc. 111-003