Tuesday, January 20, 2009

Sour on Apple's Accounting?

The Bullish Cross -- a blog I've linked to, and a good source of hard-numbers thinking on Apple -- has gone sour on Apple management. The basic argument is that in choosing subscription accounting for the iPhone, Apple has made it too easy not to understand what a whomping huge business Apple has developed in its cellphone category, and how much money that business is making Apple.

Yes, Subscription Accounting Increases Opacity
Subscription accounting has made Apple more opaque, and thus harder to value. Like Bullish Cross, this blog noted the significant impact of the subscription accounting and drew attention to the fact Apple's subscription accounting decision had led it to make non-GAAP announcements just to make sure people understood how much money Apple was making.

Opacity ... good?
At the time Apple announced its intent to use subscription accounting, I assumed the purpose was to create opacity, in order to prevent competitors from easily working out things like Apple's actual unit cost, margins, etc. associated with the iPhone. Thus, iPhone sales are mixed with other subscription sales and separated from the nearly-identical iPod Touch sales, each of which is given radically different accounting treatment. I didn't think for a minute that Apple's decision was based on a clever scheme to make money on profits while the taxes on them remained deferred by virtue of Apple's accounting scheme, because Apple doesn't make any money with its money (though it's been laudably good at not losing it, either, which says something in this environment). Apple's accounting game made sense only to the extent that it allowed Apple to reap a competitive information advantage during the phase in which it first rolled out iPhones to a market that was prepared to sleep through Apple's assault.

Opacity bad.
Fast forward to today: Apple is a plausible world smartphone leader and has an application store that dwarfs anything in the smartphone space. Bullish Cross is angry that the extent of the profitability of this setup isn't as clear to the folks to whom he'd like to sell his shares. Well, I can understand that.

The real downer is that by the time Apple's subscription accounting allows Apple to call "profit" enough subscription-quarters of iPhone revenue to approximate current sales, the growth that would place such a premium on Apple's shares would have passed. (Graph sales over time looking for the break-even point of subscription and non-subscription accounting for the phones' profit, and you'll see what I mean; it requires a sales decline or a long plateau. The more likely event is that Apple's phone revenues under the actually-employed accounting system don't reach the levels achieved by the one Apple uses for iPods anytime in the foreseeable future.) So, waiting for the future to speak the truth is just not going to happen.

What should Apple do?
Apple could declare that its subscription accounting system was based on flawed assumptions regarding the extent of software updates and simply change accounting principles, restating past earnings (upward) and setting the future straight. On the other hand, might Apple benefit from the opacity its accounting methods give it with respect to competitors? Might subscription accounting enable Apple to spread over time the impact of a subsidy if Apple were led into providing subsidies? Consider a future in which Apple is allowed -- by virtue of its longstanding accounting scheme -- to amortize subsidies across twenty-four months, while taking application and service revenues from a huge and growing user base. Might subscription accounting give Apple some flexibility Bullish Cross isn't thinking about?

This is a complex problem. Knowing what Apple should do with its accounting principles depends in part on what Apple is trying to do with its accounting principles, and whether those objectives remain present and future concerns. As profit per unit declines with per-unit overall cost (even if margins remain high, profit must decline as units drop from $500 to $100), Apple's ability to cushion this with subscription accounting while reaping software revenues could place it in a favorable position with respect to its later earnings announcements.

The kicker is that Apple is so into secrecy, nobody with solid understanding of Apple's internal rationale for the accounting decision can explain why Apple's decision is extremely clever or very stupid without facing the axe. Maybe this is an area in which future Apple leadership can offer improvement.

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