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Inside Apple's iPhone subscription accounting changes

There's an app for that

Beyond the iPhone itself, Jobs also drew attention to the new App Store by saying, "We’ve never seen anything like this in our careers. There are now over 5,500 applications offered on the App Store in 62 countries around the world and the rate of new applications being submitted is increasing every week. Competitors are scrambling to copy our App Store but it’s not as easy as it looks and we are far along in creating the virtuous cycle of cool applications begetting more iPhone sales, thereby creating an even larger market which will attract even more iPhone software development."

Unstated was the fact that a significant element behind the App Store's success was that the vast majority of the 13 million iPhones sold up to that point were all running iPhone 2.0 firmware and therefore capable of accessing the iTunes App Store, because Apple was able to offer the new OS upgrade for free because of subscription accounting. Had Apple tried to charge any nominal fee for the 2.0 update, it would no doubt have resulted in complaints that would have overshadowed the App Store launch itself, in addition to preventing many users from even considering upgrading.

Subscription accounting was both helping and savaging Apple. Everyone knew it, nothing cold be done, and yet analysts kept assailing the company and its prospects as the recession deepened. The only thing the company could do is plug away at its business until the naysaying was proven wrong by a series of blockbuster quarterly earnings reports. And in time, the record breaking iPhone sales would add up to the point where even the fractions that were being reported under subscription accounting would make an undeniable impact on the company's officially stated performance.

That began to happen earlier this year, despite efforts by rival investors to portray the iPhone as dead and soon to be vanquished by the new Palm Pre. By the middle of the year, when it became apparent that the Pre was not going to damage the iPhone, and that Apple had not been idle in its own software development plans either, investors began to see the benefits of subscription accounting at least in terms of encouraging large numbers of iPhone users to upgrade to the latest 3.0 software release. The number of iPod touch users who chose to pay a fee to upgrade turned out to be much lower.

Subscription accounting gets a makeover

In the company's most recent earnings report, a full year after Jobs appeared and begged the world to give Apple a fair shake, the company reported that it had successfully worked to convince regulators to change the rules so that it could begin to recognize the majority of iPhone revenue, and yet still provide users with free updates going forward by deferring a small part of each iPhone sale's revenue.

"On September 23, the Financial Accounting Standards Board ratified EITF 09-3, which will change the way that we account for iPhone and Apple TV today," Oppenheimer announced. "Under EITF 09-3 only the estimated sales value of future upgrade rights to iPhone and Apple TV software are required to be deferred at the time of sale with the balance of the iPhone and Apple TV sales price being recognized immediately as revenue.

"The deferred amounts will be recognized over the 24-month estimated lives of the product, similar to the way we have applied subscription accounting to these product sales today. We don’t know at this time the specific amount of revenue deferral for each iPhone and Apple TV sold under EITF 09- 3, but we do believe that a substantial portion of the revenue will be recognized for these products at the time of sale.

"We are very pleased with the FASB adoption of this new rule as we believe it will enable us to more closely align our reported results with the economics of the iPhone and Apple TV sales. We will be required to adopt the new accounting rule no later than the first quarter of our fiscal 2011, a year from now, but we do have the option of adopting earlier than that some time in our fiscal 2010. We are currently assessing the impact of the new rule on our accounting and reporting system and processes. Making this change will be complex and as of now we are uncertain as to the timing of our adoption. Therefore, we don’t have anything more specific to discuss with you today about this change.

"The guidance for the December quarter that we are providing today is based on a subscription accounting treatment that we have applied to-date for the iPhone and Apple TV sales. In other words, it is based on the assumption that the full amounts of revenue and product costs for past and future iPhone and Apple TV sales continue to be recognized ratably over the estimated 24- month lives of the product."

How the new rules will affect iPhone users

While the accounting changes will not immediately affect Apple's reported earnings, it will eventually allow the company to stop being penalized for subscription accounting while still being able to offer free updates so that users continue to upgrade promptly and maintain satisfaction with their smartphone without having to pay anything extra. This also helps third-party developers confidently target the latest version of the iPhone OS without fear that there is a large population of potential users that haven't and won't upgrade.

And of course, it also simplifies the buying experience of the App Store, as users don't have to check to see if their apps are compatible with their operating system version. Instead, Apple can force developers to certify their apps against the latest version and simply delist them from the App Store if they fail to do this, as it did in the upgrade to 3.0.

This provides the company with a competitive advantage over other mobile software platforms, where many users simply can't upgrade to the latest version because of compatibility issues with their phone. For example, Microsoft only certifies its latest Windows Mobile 6.5 to work on new phones introduced this year, despite being characterized by the company as a relatively minor update.

T-Mobile/HTC's original G1 phone similarly has hardware limitations that Android developers have warned will prevent it from being upgraded to the latest software update at some point in the future, but likely before its two year life span is up. It is believed that its early adopters will not even be able to upgrade to Android 2.0.

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Daniel Eran Dilger is the author of "Snow Leopard Server (Developer Reference)," a new book from Wiley available now for pre-order.