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Ahead of the Accounting Curve, Too

Technology giant Apple has benefited from its early adoption of new revenue-recognition rules. But for other companies, the rules could present som...
Marie LeoneMarch 25, 2010

With its iPad device ready to hit U.S. retail shelves next week, Apple continues to build on its reputation as a revolutionary technology company. But the computer giant is also ahead of the curve in accounting, as shown by its early adoption of new revenue-recognition rules.

In January Apple announced it had adopted the new rules in the first quarter of fiscal 2010, on a retrospective basis. The move enabled the company to accelerate the recognition of revenue for popular products such as the iPhone and Apple TV, giving revenues and profits a boost — indeed, the quarter was Apple’s best ever. The company also provided comparable financial results for its last three fiscal years as if the new rules had been in effect.

Apple is one of the few companies so far to adopt the new accounting rules, which were issued in September and come in two parts: EITF Issue 08-1 and EITF Issue 09-3. The rules change the way companies account for bundled products and services. Technology outfits that bundle elements such as hardware, software, software upgrades, and services into one product price are particularly affected, but the change applies to any company that generates revenue through a multifaceted arrangement. That may include, for example, a biotech firm or solar-energy company that has contracts detailing a raft of product and service milestones.

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The EITF rules come ahead of a much more comprehensive overhaul of American and international revenue-recognition rules. An exposure draft on the larger project is due out before June, but technology companies had called for quick action on the bundled-products issue. Their call was answered by the Emerging Issues Task Force (EITF), a subset of the Financial Accounting Standards Board that issues rule revisions and guidance in response to changing market needs.

Although mandatory adoption of the EITF rules is slated for the first quarter of fiscal 2011 for calendar-year companies, Apple decided to take advantage of FASB’s offer of early adoption. By doing so, the company is permitted to recognize “substantially all of the revenue and product costs” for its iPhone and Apple TV when the products are sold to customers, as it noted in its January 10-Q.

That would have been impossible under the old rules, as historically Apple was required to follow software revenue-recognition rules and book revenue using subscription accounting. Subscription accounting is used when there are “future deliverables” associated with a product. In the case of Apple, the deliverable could have been free upgrades for the iPhone, the value of which is bundled into the selling price of the device. Under the old rules, a promise of free upgrades in the iPhone product road map (a schedule of promised product and service release dates) would have forced Apple to recognize the device’s revenue over the road-map time line. That’s no longer the case.

Now, if the software is considered “essential to the functionality of the product,” a company can abandon the software-recognition rules and instead estimate the selling price of the undelivered elements, defer just that chunk of revenue, and book the rest. That accounting process is known as the relative-value method of allocation.

The rule change “allows companies to follow more of the substance of the transaction,” says Kelley Wall, senior consultant at accounting and financial advisory firm RoseRyan. “Now you can match up the elements of what you are delivering to an estimated value.”

In its fiscal first quarter, which ended December 26, Apple recorded total revenues of $15.68 billion and a net profit of $3.38 billion, compared with $11.88 billion and $2.26 billion for the same period in FY 2009. Some of the 2010 revenue can be attributed to the accelerated revenue-recognition brought on by the new rule, a transitional boost Apple is required to explain in its financial-statement footnotes. Indeed, under old rules, a natural “smoothing” of revenue took place because recognition was spread out over the life of bundled products, says Wall.

Wall notes that Apple provided three years of “great” comparative data and reconciliations to explain the changes. But she adds that companies usually find it “very challenging” to adopt rules retrospectively, “and it is my guess most companies will not do so.”

In addition to accelerating revenue recognition, there may be some instances when the new rule promotes new sales, says Wall. Consider that companies will be able to develop and release more-robust product road maps, which can be touted by the sales staff without triggering the deferral of substantial revenue recognition. “Accounting road blocks won’t exist anymore,” she says, and that could lead to an increase in product sales.

Challenges Ahead, Plus an ERP Problem

Despite the additional flexibility companies will gain by adopting the rules, management will face some nonaccounting challenges. For example, sales-commission structures may have to be reworked, because the accelerated recognition of revenue will front-load payouts to the sales staff, which could disrupt budgeting and forecasting exercises. That front-loading effect could also create more volatility in earnings, says Wall, referring to the absence of the “smoothing” effect that subscription accounting creates.

Earnings volatility also could cause companies to rethink earnings guidance, perhaps pushing them to quit the guidance game altogether. What’s more, managers will have to tread lightly when educating investors and analysts about the impact of the rule so as not to violate fair-disclosure rules. That is, says Wall, the investor-relations team must avoid getting too specific about comparable financial-statement data when explaining the new recognition timing, unless they release those details publicly.

Accounting software embedded in enterprise resource planning systems may also create pockets of havoc. Reportedly, some ERP systems cannot incorporate the relative-value method of allocation used to defer the revenue associated with each product component. Say, for instance, that a company sells a bundled product for $100, and it includes hardware, software, and a year-long service contract. Under the old rules, if the selling price of the three components cannot be calculated, then the entire $100 must be recognized using subscription accounting over the life of the product. ERP systems work fine in this situation, which calls for a specified dollar amount to be allocated over a certain time frame.

But the new rules throw a virtual wrench into the system. In the case of the $100 product, companies will estimate the value of each component and spread the revenue proportionately by percentage allocation to the various elements. That’s where ERP systems stumble, says Wall. The systems are not programmed to use the bundled price as a starting point and then break down the allocations on a percentage basis.

Last year Tivo Inc.’s corporate controller, Pavel Kovar, addressed the ERP problem in a comment letter on the new rules. “Requiring solely the relative-selling price method is not operational,” wrote Kovar, adding that using that method “will require significant and costly redesigns of accounting software which currently allow for deferral of the full fair value of undelivered elements.” Kovar said the company was also concerned about whether or not accounting-software packages would be able to simultaneously handle recognition of deferred revenue from legacy arrangements and from arrangements under the new rules.

According to Wall, accounting and IT managers are currently discussing how to approach the ERP problem, with some smaller companies suggesting the use of spreadsheets to calculate the relative value of unbundled components. In that way, the spreadsheet calculations could be fed back into the ERP system to capture the proper revenue-recognition allocations. As for larger companies, Wall says those managers are tinkering with software fixes that will allow for the new revenue-recognition calculations to be fed directly into their existing ERP systems.