Accounting rules shouldn't change to benefit Apple, other high-tech companies

The Financial Accounting Standards Board will make a grave mistake if it gives into Apple and other high-tech companies demanding a change to subscription accounting rules. FASB is preparing to vote on a rule change affecting GAAP (Generally Accepted Accounting Principles) versus non-GAAP accounting. Apple is on record as supporting the change, which would artificially boost the company's quarterly revenue and almost certainly its stock price. Some other companies, including Microsoft, could receive similar benefits.

Under current rules, companies defer subscription revenue. Since they deliver services over time, revenue is accounted for by X percentage every quarter. Microsoft has deferred revenue for years, but the numbers got really big starting in 2002, following the implementation of annuity volume-licensing contracts under Licensing 6. Four times a year, Microsoft states the total unearned revenue, how much deferred revenue it realizes as real revenue and how much more the company gains each quarter.

Nearly 12 months ago, Apple started reporting GAAP and non-GAAP results side by side -- with fiscal 2008 fourth quarter earnings. CEO Steve Jobs clearly was dissatisfied with not officially reporting iPhone revenue, a large portion the company deferred. In an uncharacteristic appearance, Jobs joined the fiscal fourth quarter earnings call, where he droned on about GAAP versus non-GAAP reporting and how much higher Apple results would be when adding subscription revenue.

"Subscription accounting is the solution we adopted to let us provide free software updates to iPhone users under GAAP accounting rules," Jobs told financial analysts. Non-GAAP results "eliminate the impact of subscription accounting," which is a strange way to describe deferred revenue, unless the objective is to convey stronger performance regardless of accounting standards. For that one quarter, Apple revenue would have been 48 percent higher when accounting for subscription revenue.

By reporting GAAP and non-GAAP side by side, Apple did something most companies don't ever do. For a reason. According to FASB standards, GAAP results are those officially reported. Sure, Microsoft and other companies report non-GAAP results on paper, but not side by side or aggressively as Apple did a year ago and continues to do today.

It's sensible that Apple report non-GAAP earnings on some basis, if for no other reason than comparison to other mobile phone manufacturers using similar subscription revenue accounting methods. For example, Nokia reports non-IFRS (International Financial Reporting Standards) results.

Changing the Rules

The rule change is already approved in draft stage, which was a mistake that the vote could compound. I see industry lobbing to change GAAP/non-GAAP reporting as attempt by some companies to manipulate their quarterly results and share values. For Apple, the ability to add currently non-GAAP results to GAAP would be huge. For example, during fiscal 2009 third quarter, Apple reported revenue of $8.34 billion and $1.23 billion net quarterly profit. To get a sense of how much Apple executives loathe non-GAAP reporting, I will quote from the fiscal third-quarter press release:

Adjusting GAAP sales and product costs to eliminate the impact of subscription accounting, the corresponding non-GAAP measures for the quarter are $9.74 billion of 'Adjusted Sales' and $1.94 billion of 'Adjusted Net Income.'

The current rules are goddamn sensible, because deferred revenue encourages accountability. Apple and AT&T sell iPhone under two-year contracts and deliver software updates over time to the smartphone and to iPod touch. Apple shouldn't get the benefit of money upfront for a service delivered to the buyer over X time period. Deferred revenue accenuates Apple's obligation to its iPhone buyers.

Something else: Device, service and software are intertwined. In an October 2007 blog, I asked, " Who owns iPhone?," after an Apple software update bricked some devices. That Apple can so easily change the device raises questions about ownership and how much the device-service-software is more of a lease, which by definition is a subscription. Similarly, Jack Consumer buys iPhone, which requires a carrier (presumably AT&T in the United States) and ongoing software updates from Apple. This binding of device, service and software demands accountability, which revenue deferral offers as customer obligation. The rule change would remove the obligation subscription accounting creates.

Microsoft could also benefit from rule changes, and it should not. Under current FASB guidelines, Microsoft must defer revenue from annuity licensing contracts, which obligate the company to deliver upgrades and other services to subscribers over two or three years. For fiscal 2009 fourth quarter, Microsoft's reported income was $3.987 billion. But the number would have been $4.391 billion when reconciling GAAP and non-GAAP results.

Questioning the Reporting Record

Apple isn't the only high-tech company asking for the accounting changes. But it is perhaps most prominent, because of blogs and news stories posted last week. Many stink of bad reporting or Apple bias. I don't care which reason, as I'm going to piss all over them. I've randomly picked examples.

At the Apple 2.0 blog, Philip Elmer-DeWitt wrote that "Subscription accounting meant that Apple has been under-reporting earnings on its bestselling smartphone for two years." Say, what? Apple hasn't under-reported anything. Apple recognizes a portion of the deferred each quarter, which is like having money in the bank.

At ArsTechnica Chris Foresman wrote:

Apple ended up having to report two sets of figures for its quarterly and yearly earnings reports: GAAP (generally accepted accounting principles) earnings, using the subscription revenue for iPhones, and non-GAAP earnings, which include the full revenue from iPhone sales. Needless to say, Apple would prefer to report the non-GAAP numbers, since it is a more accurate representation of the company's performance in a given quarter.

Apple wasn't forced to report two sets of numbers. The company chose to. The numbers as stated are accurate per quarter, if services revenue is deferred over the life of the subscription.

At Engadget, Nilay Patel wrote that Apple's "stock price doesn't always reflect the true amount of iPhone money coming in -- in fact, Apple earnings reports now include a second, unofficial balance sheet that does away with subscription accounting to show off the real numbers."

The GAAP results are real numbers. Of course, the meaning of those real numbers will change if FASB votes to officially put new rules into place. I contend that revised rukes would be dishonest, unless the buyer is allowed to pay for the product or service over X time period -- the life of the contract. Payments over time would quite accurately reflect company revenues and further keep it honest.

Do you pay the guy doing repair work on your car, computer or home up front in full before any service is performed? No. You might pay something, but not the whole amount until the work is completed. The iPhone is a work in progress, as evidenced by two full software upgrades and ongoing updates. Should Apple reap before it sows? I say no.