AICPA Statement of Position 97-2 from 1997 required that if a firm made a multiple element sale that included software, the revenue must be pro-rated over the life of the contract using the subscription model unless the firm had vendor specific evidence as to the value of each element comprising the sale.
When Apple sells an iPhone, it offers free software updates for about two years. Because Apple does not sell the software separately, it has no evidence as to the fair value of the software. As a result, Apple recognized revenue from iPhone sales equally over a 24 month period. If it sold an iPhone for $480, its initial journal entry would be a debit to cash for $480, a credit to revenue for $20, and a credit to unearned revenue for $460.
Because the cost of software is trivial relative to the value of the hardware, nearly everyone ignored Apple’s reported net income. Instead, they treated the sale as if all revenue should have been recognized on the sale date. As iPhone sales grew, Apple had nearly $12 billion of deferred revenue at year end September 26, 2009.
In October 2009, possibly in response to Apple’s deferred revenue, the FASB issued two Accounting Software Updates that substantially changed reporting rules for sales with multiple elements that include software. The primary change was that firms no longer needed specific evidence for the fair value of each element in a sale that included software; management judgment would be sufficient. This case covers Apple’s January 25, 2010, retrospective restatement of its 2009 financial statements because of changes to those rules. The restatements increased Apple’s 2009 pre-tax net income by $4.1 billion and its 2008 pretax net income by $2.1 billion. The revised financial statements had no detectable effect on Apple’s share price because investors essentially ignored Apple’s use of SOP 97-2.