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Tutorial week 1Tutorial questions week 1
1. Why do you think Apple introduced the iPhone Upgrade Program? What might be the added
value of the program from the customer’s perspective?
2. How does Apple account for the revenues from regular sales of iPhones (i.e., outside of the
Upgrade Program)? How did the changes in accounting under the “2009 rule” affect Apple’s
balance sheet and income statement?
3. How does the Upgrade Program affect the way in which revenues are recognized by Apple
compared to iPhones sold outside of the program? Explain conceptually how this change
affected the income statement and balance sheet.
4. Look up the numbers provided in the case on the selling price of iPhones and the gross
margin. Use these numbers to provide the journal entries related to the sale of one iPhone
under the Upgrade Program. Assume that Apple expects customers to trade in their phone
after 1.5 years.
5. Because Apple reports on a quarterly basis, it updates its estimates of customer trade-ins at
the end of each quarter. Assume, hypothetically, that you are in charge of the financial
reporting at Apple and that you need a small amount of additional earnings to meet the
expectations set by outside equity analysts. How would you change the estimates?
6. Assume that as an analyst, you believe that Apple has mis-estimated customers’ phone
trade-ins and this has caused the company to overstate its fiscal 2016 revenues by $5,000
million (i.e., $5 billion). Compute the changes in Apple’s assets, liabilities, and equity that
would result from undoing this perceived overstatement of revenues (assume that Apple’s
marginal tax rate equals 25 percent).
1. Why the Iphone Upgrade Program? – Not exam material for this part
- From Apple’s perspective:
o Average upgrade time increased from 18 to 26 months → increase turnover
o Taking control over the customer relationship
▪ Direct contact with customers instead of carrier in the middle (like Verizon).
o Entering market for used phones and emerging economies (India, China)
▪ They couldn’t really sell it at a high price so they now can use those second
hand phones.
- From customer’s perspective:
o Low monthly payments
▪ Spreading out the price
o Zero percent interest rate on loan
o Upgrade option
o Unlocked phone
o Better service through AppleCare+
- Citizen Bank also has additional business
- Carriers aren’t happy, because they are dealing with this loss of being ‘locked out’.
2. Accounting for regular iPhone sales
- Products like iPhones are examples of products with “multiple deliverables”
, o Hardware component: the phone
o Service component: future software upgrades
▪ The quality of the product depends on something that you need to provide
on an ongoing basis
- This implies that selling one iPhone for $649 requires Apple to account for the revenues from
the hardware and service components in different ways:
o Recognize the full $639 in revenues for the hardware component at time of sale (and
recognize costs)
o Spread out recognition of $10 service component over 24-month period
o At the end of each quarter, you have
earned 1/8
o Relevance / reliability: new method
is more relevant, with the new
method it is much more timely.
▪ In new method, if no one
buys your product suddenly
anymore you will not see
this in the method before
prior to 2009.
- While Apple has to defer the recognition of revenues for only a small component (),
the recognition of iPhone sales was very different before the “2009 rule”
o Before 2009, Apple had to defer the recognition of all of the revenues
o It was not allowed to separate the hardware and software components
In 2008, Apple disclosed the effects of undoing the conservative nature of accounting rules pre-2009.
Apple’s (“non-GAAP”) accounting
adjustments:
Q: What would be the effect on the balance
sheet of undoing this accounting
treatment?
Big difference, as an investor, you are
looking for the best number. The less
conservative (non-GAAP) vs the non-
conservative number. In this case, Apple provided this number themselves (not yet allowed by
,GAAP), so now this number becomes less reliable → more discretion. That is the issue with voluntary
disclosures, we are not sure whether we can trust them, so there is a trade-off.
From Exhibit 4, we learn how the change in accounting after 2009 changed Apple’s balance sheet:
The earlier recognition of (most) of the revenues post-2009 caused a huge decline in deferred
revenue balances on Apple’s balance sheet.
- Old one had a lot of deferred revenues and now it is much less. Nothing changed in the
underlying business of the company, just an accounting change. But the numbers changed
materially. Be aware of this!
3. Accounting for sales under the Upgrade Program
- What are the key features of the Upgrade Program that make the transaction unique?
o AppleCare+ automatically included in the packages ($129), but let’s ignore this
component here
o Customer enters a 24-month loan contract with Citizens Bank
o Apple immediately receives the full amount from Citizens Bank
o Customer has the option to trade-in phone for a new model after 12 monthly
instalment payments
▪ How many people, when and in what condition?
▪ Apple collects and refurbishes the old phone
▪ Apple pays back the remaining loan to Citizens
▪ Customer automatically enters into a new 24-month loan contract
- How should these changes affect the accounting?
o What other type of transaction does the Upgrade Program compare to? → Right to
return
- We can compare the transaction to a sale with a “right to return”
o Customers have the option to return the product and to get a (partial) refund of their
payment
- Accounting standards (both IFRS 15 and US GAAP) require a company to:
o Reduce the amount of revenues to be recognized by the expected rate of product
returns
o Recognize an asset (and corresponding adjustments to costs of goods sold) for the
products expected to be returned from customers in the future
- At the time of sale, Apple should now additionally account for the upgrade option:
o Apple should limit the amount of revenues recognized and recognize a liability for
the remaining amount
, o Apple knows how good your old phone is, how much storage space they have etc,
and how much better the new one is going to be so they are in the best position to
come up with an estimate.
▪ Why?
▪ Apple has the obligation to pay Citizens the remaining loan amount when
customers decide to exercise the upgrade option after 12-24 months
o At the same time, it should recognize a “right-of-return” asset
▪ This captures the minimum expected market value of the used phone when
a customer returns it
o What is the key accounting challenge here?
- Additional accounting considerations:
o The potential costs associated with “buying back” used phones after 12-24 months
(refurbishing costs)
o The potential costs and losses from holding refurbished phones in inventory
(impairments)
4. Journal entries
- Assume Apple expects customers to trade in phone after 1.5 years.
o Let’s ignore the AppleCare+ ($129) and software ($10) components.
Suppose that Apple comes up with an
estimate of 1.5 year. How does the
accounting change now?
You translate whatever estimate they came
up with into the liability that we talked
about (the magnitude of this number
depends on the percentage (expectation)),
you need the liability and you know you are
going to get back some phones.
1,5/2 = 0,75 → 75% Revenues
5. Impact of changes in estimates
- Estimating when and how many customers will exercise the upgrade option is a subjective
exercise
- How would changing the estimate of 1.5 years change the company’s earnings?
- Assume customer is expected to exercise option one quarter earlier:
Take 70% on cost side.
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