The Financial Accounting Standards Board is giving Apple an early present this year—revised accounting standards. While that may not sound like much of a present to you or me, the revision by the FASB allows Apple to more accurately report their quarterly revenue. In the recent past, Apple has struggled to accurately report the amount of revenue they receive each quarter from their sales, a problem which the iPhone and its two-year contract have only exacerbated. The new regulations will allow Apple and other companies to immediately recognize most of the revenue from subscription products like the iPhone.
“Revenue is the one of the, if not the most important, biggest, and valued item in firms financial statements,” said Anup Srivastava, assistant professor of Accounting Information and Management. “The problem is occurring where contracts are to be fulfilled over an extended period of time.” In other words, when you walk out of an Apple store with a new iPhone in your pocket, Apple’s side of the transaction is far from over. Apple’s commitment to provide software updates for the life of the device meant under previous rules accountants had to record your purchase not as a one time event, but a string of payments over two years.
Before the new revision, FASB rules complicated the reporting of subscription sales like the iPhone. Apple, for example, could only recognize the bulk of the revenue from the iPhone if it could establish prices for the individual components the sale—hardware, software, and services. Additionally, they also had to establish what’s called a vender specific object of evidence, or VSOE. (If you’re starting to feel inundated by acronyms, you’re not alone—accounting is full of them.) VSOE requires companies to establish the price of those individual components based on prior transactions within the company. Similar products by other firms don’t count. For Apple, there was no precedent within the company for the iPhone, so the company was forced to take a conservative approach by allocating iPhone revenue evenly over the two year contract.
Thanks to the success of the iPhone and the other devices like the Apple TV (another subscription-based product), Apple is sitting on $12 billion in deferred revenue, Srivastava said. The new changes, he said, should allow Apple to whittle down the amount of deferred revenue and more accurately report revenue from its subscription sales in the future. The FASB changes will give companies more flexibility when allocating prices to the different portions of a bundled product. Many companies, Srivastava expects, will report larger costs up front and defer smaller portions of revenue to things like software updates than before.
While one analyst thinks the change in FASB rules will push Apple’s stock price higher, Srivastava disagrees. “[The deferred revenue] has all been disclosed. And anything that has been disclosed is priced right by the market.”
Current subscription based accounting practices were derived from an unlikely source—project, or construction, accounting. When construction firms are working on a project, an FASB rule provides access to revenue from the project during construction, not just upon completion. Software companies adopted this principle for a similar purpose in the late 1990s. Realizing the potential for confusion, the U.S. Securities and Exchange Commission requested in 2002 that FASB to address the bundled products that were becoming more prevalent in the high tech industry. This week’s recommendation is the latest result of this ongoing effort.
While the revision may seem minor and academic, its effects could be significant. NEC voluntarily delisted from Nasdaq because of difficulty in determining VSOE, one of the prerequisites to recognizing earnings from bundled products up front. With the changes, though, Srivastava believes NEC may be able to relist on a U.S. stock exchange.
“This is sort of a quick fix,” said Srivastava. “FASB is still discussing the revenue recognition project, which is going to be a comprehensive revenue recognition standard.” The full revisions, though, are not due out until 2011. Until then, companies are free to use the new change on an as-needed basis.