How Steve Jobs and the iPhone Changed GAAP Revenue Recognition
20 Apr 2021Unable to convince skeptical shareholders of the iPhone’s impact, Steve Jobs helped change GAAP revenue recognition standards.
“Phone differentiation used to be about radios and antennas and things like that. We think, going forward, phone differentiation will be about software.” - Steve Jobs, 2008
A great vision. Unfortunately, the investing public was not easily won over. Neither by these words nor by the 1m units sold in the first three months. In fact, Apple’s stock declined during the year after its debut.
We are used to thinking of the iPhone as one of the greatest product launches of all time. But it was more complicated for Steve Jobs and the Apple Finance team. GAAP revenue presented in their quarterly earnings was far more modest than what the brisk pace of unit sales would suggest. There was a disparity between observable facts on the ground and official reporting of what was taking place.
Revenue recognition rules were responsible for this disparity. As Apple’s CFO explained at the time, “Since we will be periodically providing new software features to iPhone customers free of charge, we will use subscription accounting and recognize the revenue and product cost of goods sold associated with iPhone handset sales on a straight line basis over 24 months.” (Italics mine)
In a nutshell, future upgrades of iOS had no ascertainable value as a stand-alone item. This fact required Apple to defer the entire amount of the sale, not only the value of upgrades. And this meant that after the iPhone was brought to market, sales were piling up as deferred revenue on the balance sheet, dampening the iPhone’s positive impact on the company’s performance.
Apple would have preferred to estimate a value of delivering upgrades and defer only that portion. The iPhone (hardware and software available at time of purchase) could then be recorded as revenue at the point of sale in the same way that the Mac or the iPod was. But this would involve allowing managerial estimates to influence revenue reporting, something that was frowned upon due to subjectivity and the potential for abuse.
So what did Steve Jobs do about the revenue reporting nighmare? He did two things. First, he presented non-GAAP revenue in a rare earnings call appearance, bringing attention to the limitations of GAAP subscription accounting in understanding iPhone revenue. And secondly, he pressed Apple’s concerns with standards setting bodies, resulting in a change to US GAAP known as the “Apple Rule”.
It is challenging even now to show the economics of what you are accomplishing with your software-defined products. This is particularly true when software and hardware are bundled together, or when you give customers some kind of beneficial element for free.
(Read more about Apple’s early iPhone revenue recognition problems here)