Apple 2.0

Covering the business that Steve Jobs built

Accounting rule change in Apple's favor

September 14, 2009: 9:51 AM ET
Image: FASB

Image: FASB

A change in accounting rules for which Apple (AAPL) -- among other high-tech companies -- lobbied heavily won tentative approval last Thursday. The change could significantly affect both the company's reported earnings and its stock price.

The new rules are in draft form and must still win final approval from the FASB -- the organization empowered by the SEC to set accounting standards in the United States.

But they have the force of law. And they could put an end to iPhone subscription accounting, a balance-sheet sleight of hand required by the old rules that has confused analysts and investors from the day the iPhone hit the market.

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.

It's not clear when the rule change will take effect; one option on the table is the start of Apple's next fiscal year, which begins in less than two weeks (although Apple wrote the FASB earlier this month asking for more flexibility in terms of timing).

But whenever it happens, the impact on Apple could be dramatic. In the company's third fiscal quarter, for example, it reported earnings of $1.35 per share using the current generally accepted accounting principles (GAAP). Its so-called non-GAAP earnings, by contrast, were $2.14 a share -- 58.5% higher.

"It is our belief," Apple controller Betsy Rafael wrote the chairman of the FASB's Emerging Issues Task Force in August, "that investors, analysts and preparers would benefit significantly from the proposed changes ... [The current rule] often results in accounting that does not reflect the underlying economics of transactions and can result in financial reporting that lacks the transparency necessary to fully inform users making investment decisions." (link to pdf)

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.

Apple is not the only company that finds itself in this situation. Software makers like Microsoft (MSFT) and Oracle (ORCL) that do a lot of enterprise business are in the same boat. And indeed, Apple was one of dozens of companies, from TiVo (TIVO) to Xerox (XRX),  that wrote to the FASB in support of the rule change.

But it could be argued that no company's product has been more misunderstood by more investors because of the old rules than Apple's iPhone.

The FASB's Emerging Issues Task Force met on Sept. 9 and 10, and decided in favor of the rule change on Sept. 10, according to Credit Suisse's accounting and tax research team. A meeting originally scheduled for Oct. 15 has been canceled; the next meeting is penciled in for Nov. 18-19.

For more on iPhone subscription accounting, see:

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About This Author
Philip Elmer-Dewitt
Philip Elmer-DeWitt
Editor, Apple 2.0, Fortune

Philip Elmer-DeWitt has been following Apple since 1982, first for Time Magazine, and now on the Web for Fortune.com.

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