Thursday, September 24, 2009

Revenue recognition rule change may boost earnings (AAPL, PALM)

AlphaNinja - Reuters is reporting that a rather odd (in my opinion) accounting rule may be changed in favor of certain tech companies.

The change relates to the way revenue is recognized for products -- such as smartphones -- that combine hardware and software. Previously, such devices were governed by accounting rules that applied to software. Under accounting guidelines for software, revenue is recorded over a product's expected life cycle, typically years. "If you had a product that had both a hardware element to it and a software element ... if the software was critical to it, then you had to follow the software rules," said Brian Minnihan, a partner in the technology practice of accounting firm BDO Seidman. The change takes effect for fiscal years beginning on or after June 15, 2010, but earlier application is permitted. Minnihan said some companies may choose adopt the new rule as early as the current quarter. Analysts say the accounting change will likely have the most impact on Apple, whose sales of the popular iPhone has not been fully reflected in its quarterly results.

This delayed (or smoothed over a period)revenue recognition usually does not apply to hardware - instead it is meant to prevent software companies from recognizing revenue (and the bump in the stock price) from a massive software installation that may be more costly/complicated/delayed to the seller than previously thought. So that's why it seems a little burdensome to apply it to iPhone sales, just because Apple(AAPL) may provide free software upgrades over the life of the product.

As Apple describes in their most recent 10q:

For both Apple TV and iPhone, the Company has indicated that from time-to-time it may provide future unspecified features and additional software products free of charge to customers. Therefore, sales of Apple TV and iPhone handsets are recognized under subscription accounting in accordance with SOP No. 97-2. The Company recognizes the associated revenue and cost of goods sold on a straight-line basis over the currently estimated 24-month economic lives of these products, with any loss recognized at the time of sale.
Of critical importance - this will give APPL a huge boost to GAAP(Generally Accepted Accounting Principles) earnings, but cash flow will not change. Apple provides a peek at non-GAAP earnings when they report results, so I wouldn't expect a huge change in investor sentiment over this rule change. Most astute investors know that due to this accounting, actual earnings have been understated, but it does show up in higher cash flow and non-GAAP earnings.

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