Image source: Apple.
On Apple's (AAPL 2.15%) earnings call earlier this week, CFO Luca Maestri made a few interesting announcements that were little more than footnotes to his prepared remarks. Maestri noted three minor accounting changes that were about to take place:
- For iPhones sold through Apple's upgrade program, revenue will be reduced up front by the cost associated with the program.
- Based on a market analysis, Apple is reducing the estimated selling price of future software upgrades that are deferred for each iOS device and Mac.
- The deferred revenue period for iPads is being elongated from two years to three years.
Let's consider the importance of these changes to investors.
One of these is not like the others
The first is pretty negligible. Apple has acknowledged that its iPhone Upgrade Program, while popular at its U.S. retail stores right now, is a tiny portion of worldwide sales. The majority of iPhones are either sold internationally where the program is not available or domestically by carriers offering their own set of installment or leasing upgrade programs. The third is also fairly minor, since stretching out the iPad deferral by another year doesn't have as much of an impact since the iPad is just 10% of TTM revenue.
The second one is the important one here. Apple has long deferred a portion of a product's sales price, since the company offers free software updates and non-software services for many years following the initial purchase. For accounting purposes, Apple must assign a value to these updates and services and then recognize that value ratably over time.
The amount of deferred revenue sitting on the balance sheet has steadily risen over time as Apple's unit sales have increased, and it continues to give away more and more free software over time.
Data source: SEC filings. Calendar quarters shown.
The reduction per unit will be between $5 and $10. The net effect of this reduction is that a greater portion of the sales price will be recognized as revenue up front, with a smaller amount being deferred over time. As such, this translates into a boost for both revenue and gross margin. Since there is no additional cost here, gross margin will also benefit.
Perhaps more interesting is that this move is a reversal of a similar change made exactly two years ago. Back then, Apple increased the deferral amount by about $5 for iOS devices and $20 for Macs. This brought the total deferral amount to $15 to $25 per iOS unit (recognized over two years) and $20 to $40 for Macs (recognized over four years). This change affected the guidance that Apple provided at the time for the following quarter, expecting a $900 million sequential increase in deferred revenue. I estimated the gross margin impact at 98 basis points.
Is this because of Microsoft?
Apple cited "an analysis for marketing offerings" as the reason for the change. It just so happens that Microsoft (MSFT 1.57%) has been reducing its prices for Windows 10, and is now offering its latest and greatest operating system as a free upgrade to eligible consumers.
Technically, Windows 10 is only free under a promotion for the first year, but obviously Apple is open to changing the deferral amount based on market conditions. Windows remains the dominant desktop operating system, so Microsoft's change would undoubtedly affect the market for operating systems.
Android has always been free, and since Microsoft is now the primary vendor of Windows Phones, it's difficult to allocate a value to Windows 10 Mobile as well.
In any event, the reduction of the deferral amount will give revenue and margins a small boost going forward. Investors worried about the impact last time around, but the benefit is being overlooked this time around.
