Accounting Shift Would Lift Tech Profits

By MICHAEL RAPOPORT, YUKARI IWATANI KANE and BEN WORTHEN Accounting regulators are poised to approve a rule change that could lift the earnings of technology companies such as Apple Inc. and Palm Inc. The change, which could also boost profits at biotech, medical-device and auto companies, is an attempt by accounting-rule makers to keep up with increasingly complicated products on the market that bundle hardware, software and services. The new rules will have their biggest impact on products that include both software and hardware, such as smart phones like Apple's iPhone and Palm's Pre. The rules are expected to be approved Wednesday by the Financial Accounting Standards Board. Currently when a company sells devices like these, it gets the cash up front, but can only book the revenue and profits from the sale over time, typically over the length of a product's life. Under the new rules, companies will be able to book much more of the revenue when the product is sold. A company that has strong sales in a quarter would likely record higher profits under the new rules than the old. The old standard helped smooth out the differences between good and bad quarters. Among the tech companies that publicly supported the rule change are Apple, Palm, Cisco Systems Inc., Dell Inc., International Business Machines Corp., Xerox Corp. and Hewlett-Packard Co. One of the rule change's biggest potential beneficiaries is likely to be Apple, maker of the iPhone. While Apple receives the cash from iPhone sales immediately, current accounting rules dictate that it has to book its revenue over the length of time a consumer is expected to use the device, generally considered two years. That means the sale price of an iPhone is spread out over eight quarters, so a specific quarter's revenue includes one-eighth of the value of sales that quarter mixed in with one-eighth each of past quarters' sales. Apple accounts similarly for sales of Apple TV, which allows viewers to watch online video on their TV sets. As a result, Apple, in its quarter ended June 27, said its $8.34 billion in revenue would have been 17% higher and its $1.23 billion in earnings 58% higher if revenue was recognized all at once. Its iPhone business, which appears to comprise just 20% of its overall revenue under current accounting, is likely to be a much bigger portion after a rule change, analysts say. An Apple spokesman declined to comment on the rule change. Smart-phone maker Palm also recognizes revenue for its new Pre device over a two-year period under the current accounting rule, meaning it didn't get the benefit of the early surge in sales. Last week, Palm posted an 81% decline in revenue for its quarter ended Aug. 28 and blamed almost all of that drop on the current rule. Palm declined to comment on the rule change. The rule change is designed to fix an accounting issue that many companies have faced as they increasingly bundle hardware, software and services. While hardware sales are booked immediately, sales of software are generally booked over time, because software itself comes in a bundle of different elements -- installation, training, maintenance and future upgrades -- and companies often have to wait to recognize the sale until all of those pieces are delivered. When devices combine hardware with software, the entire sale is generally treated as software under the current rules. Under the change, companies could recognize the hardware portion of the devices' revenue and the value of some software upfront; the rest of the software portion of the revenue would still be recognized gradually. Companies will be able to use their best estimates of the components' stand-alone sale prices in determining how the revenue gets allocated, but that could be tricky to determine because often the components aren't sold by themselves. A person familiar with the thinking of a FASB task force that approved the accounting switch earlier this month said it was "trying to align the accounting better with what the economics of the transaction were." People who buy the iPhone feel like they are getting the full value of the phone right away, not spread out over two years. Besides technology, other industries that are expected to get a boost include makers of medical devices that require cartridge inserts that are frequently replaced; autos sold with lifetime maintenance services; and biotech agreements that include both licenses and research and development services, according to a draft report by the FASB task force that examined the rule change. Like the hardware-software devices, these deals involve sales that bundle multiple goods and services together. At least 60 companies in the Standard & Poor's 500 have discussed such bundled-revenue arrangements in their financial statements, said David Zion, a Credit Suisse accounting analyst, in a research note. Some accounting experts are concerned because the rule change could give companies more flexibility in estimating the value of the individual parts of a bundled product. "We suggest investors proceed with caution," Mr. Zion said in a research note. He added that investors need to evaluate whether a company's changes in recognizing revenue truly reflect the economics of a transaction or "whether it simply reflects management's preferred view of the business." Others believe that the changes clarify a company's earnings picture for investors. The rule change "improves transparency," said Shaw Wu, an analyst for Kaufman Bros., adding that it will make it easier to evaluate companies' performance. If approved, the change would take effect in 2011 for most companies, though they would be allowed to adopt the new rule earlier. The change would apply to new transactions with the option of restating prior periods. Write to Michael Rapoport at Michael.Rapoport@dowjones.com, Yukari Iwatani Kane at yukari.iwatani@wsj.com and Ben Worthen at ben.worthen@wsj.com