Iphone

Source: Apple.

Last week, Apple (NASDAQ:AAPL) unveiled a brand-new early upgrade program alongside the new iPhone 6s and 6s Plus. The new program is similar to the installment and leasing plans that the national carriers have all launched, and it also threatens to commoditize them further if Apple sees even moderate success. Apple has long relied on recurring revenue from a never-ending upgrade track, and the new program makes that process easier than ever before.

Word on the Street
UBS analyst Steve Milunovich put out a research note this week detailing why he's so bullish on the new upgrade program. He believes that the iPhone Upgrade Program can effectively turn the iPhone into an annuity business, and his colleague Gareth Jenkins took it an extra step by analyzing comparable valuations and figured that Apple would be worth over $200 per share if it were priced in line with peer annuity businesses.

An accelerated upgrade cycle could translate into 9 million incremental iPhone unit sales in fiscal 2017, according to Milunovich (assuming 15% uptake of the U.S. iPhone installed base). Despite the increase in secondary market volumes, Apple would greatly benefit from the boost from selling more in the primary market.

One more reason: outsourcing
Apple is outsourcing the financing of these installment plans to Citizens One. You might wonder why it would outsource financing considering the sheer amount of cash it has on the balance sheet. Well, it's worth remembering that Apple outsources many of its financing alternatives in many markets to partner financial institutions, such as Barclays and Citizens One in the U.S. and China Merchants Bank and ICBC in China.

Iphone Upgrade Program

Source: Apple.

In doing so, Apple doesn't have to deal with any of the underlying credit risk, nor does it have to concern itself with servicing loans. Apple is not a financial institution, and it has no ambitions of becoming one. Yet it reaps the most meaningful benefit in the form of increased sales and all it has to do is ink partnerships.

There's also another possible reason why Apple does it this way.

By outsourcing financing, Apple is able to collect on sales up front and recognize that revenue immediately. Generally speaking, companies are allowed to account for installment sales in one of two ways: the installment method or the accrual method. Under accrual accounting, companies recognize revenue once a sale is made independent of cash flow. Under the installment method, which is much more appropriate if a customer is paying over multiple years (such as in the case of these new upgrade programs), revenue is recognized ratably over time.

The installment method is more conservative, and better incorporates the inherent credit risk associated with these types of transactions. It's a common accounting method for things like real estate or industrial machinery, but is also applicable for consumers taking out multiyear installment plans on gadgets.

If Apple handled all of its financing in-house, it would have to deal with all of these issues. The accounting implications also suggest that iPhone revenue would technically be under pressure since it would be spread out over such a long period of time, with a large portion of sales being allocated to deferred revenue. The only time that Apple has reported non-GAAP results in recent memory was back when it had to account for iPhone sales as subscription revenue, recognizing revenue over two years, but that all changed in 2009 anyway.

As it stands, it's best to leave financing to the financial institutions and iPhone making to the iPhone maker.

Evan Niu, CFA owns shares of Apple. The Motley Fool owns and recommends Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.