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Wednesday, October 21, 2009, 10:30 am PT (01:30 pm ET)

Inside Apple's iPhone subscription accounting changes

Apple's April 2007 Q2 earnings call announced that the company planned to book revenue for its new iPhone and Apple TV using the "subscription method of accounting," a decision that startled analysts and left many users confused. Here's what resulted and why the company is working to reverse the decision.

At the time, Apple's Chief Financial Officer Peter Oppenheimer explained that the reason for subscription accounting was that the company had big plans to aggressively deliver a series of rapid software updates for the upcoming new iPhone. However, rather than planning to make money on these updates, the company wanted to deliver them to users for free to help ensure that users would actually install and use the latest updates rather than balk at upgrade fees.

It had already been proven that smartphone users were not quick to upgrade their software. In fact, few mobile software vendors had ever delivered regular new software updates to subscribers before. Instead, most vendors simply reserved new updates for the latest phones. RIM's BlackBerry OS, the Palm OS, and Nokia's Symbian OS occasionally delivered upgrades for users, but in many cases end users only got the latest update when buying a new phone with that software installed.

Microsoft had somewhat uniquely attempted to set up its Windows Mobile platform to deliver regular new upgrade releases that users could pay for because unlike Nokia, Palm, and RIM, Microsoft didn't directly make any money on hardware sales. But this plan didn't work out as expected. Few users opted to buy upgrades, and in many cases every new major release of Windows Mobile advanced its requirements to the point where it couldn't really run on any existing phones anyway.

Having surveyed the historical smartphone software landscape, Apple plotted out a series of major OS updates it planned to deliver for the iPhone along with minor update releases that would be issued in between. This strategy was patterned after the company's Mac OS X releases, although by 2007, Apple's desktop operating system had matured to the point where its annual pace of new reference releases was being relaxed to about every year and a half (at the request of third party developers who were breathless from trying to keep up with the rapid-fire updates Apple had been releasing, below).

While Apple had long charged $129 for its major new reference releases of Mac OS X, it did not expect to be able to charge anything significant for its iPhone OS updates, in keeping with what it had observed with other mobile platforms. Instead, the company determined that it would be better to offer free software updates, which would help ensure that the iPhone's user base would upgrade to the latest release as quickly as possible.

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Enron and the Sarbanes-Oxley Act of 2002

Apple's plan to sell the iPhone and then deliver free updates for it throughout its two year lifespan brought the company under relatively new American accounting rules that had been signed into law five years earlier: the Sarbanes-Oxley Act of 2002. This law had been put into place in response to high-profile corporate fraud involving Enron, Arthur Andersen, WorldCom and Tyco, which had erupted around 2000 in tandem with (and helping to cause) the dotcom bubble burst.

One of the problems that the Sarbanes-Oxley Act attempted to address was "mark to market accounting," which Enron had adopted in the early 90s to record its natural gas profits. Instead of recording its actual costs and revenues at the time of selling its gas (as it had previously), Enron convinced the US Securities and Exchange Commission to allow it record estimated profits for long term contracts at the current value of net future cash flows. Essentially, Enron was counting chickens before they hatched.

This accounting scheme allowed Enron to meet or exceed investors' expectations by simply signing new contracts. It became so easy and addictive to report fantastic profit projections that Enron applied the scheme to other types of business as well. For example, in 2000 Enron partnered with Blockbuster Video to sign a twenty year agreement to provide on-demand TV services. While analysts were skeptical of the deal, its technical viability and consumer demand for the services, Enron estimated it would make over $110 million and immediately began booking these future estimated profits. Even after things fell apart and Blockbuster pulled out of the deal, Enron continued to book those future profits that would never materialize.

This scheme, along with a variety of other accounting tricks, was blessed by Enron's Anderson auditors, who also worked to silence any criticism of the tactics. Once the SEC began investigating, Anderson scrambled to shred all the evidence. While some of the principles involved were sent to prison over the scandal, it resulted in a disastrous impact upon Enron's investors, including former employees who had pensions held by the company. Enron alone lost $74 billion in stock valuation over four years, $45 billion of which was attributed to fraud.

Based on research into what allowed this to happened, the Sarbanes-Oxley Act was instituted to require certain minimum standards of financial accountability. Among its many rules is a provision that states that companies can't immediately book revenue for a product if the complete product has not yet been fully delivered. If a software upgrade materially changed the features of the product, the vendor would have to charge extra for that upgrade because delivering it for free could result in Enron-style accounting games where companies would sell unfinished products and simply promise to finish them in a later upgrade that might never be delivered, falsely inflating their reported revenues as Enron had.

On page 2 of 3: Apple, 802.11n, and Sarbanes-Oxley.