Jerry Brito

SOX sucks: The case of Apple

At an Apple Store a few weeks ago a clerk had to take down info from my driver’s license so that I could qualify for the education discount that previously only required that I flash my school ID. “Sorry, Sarbanes-Oxley,” she said. Really? “Yeah. Also, if you buy a custom Mac now, you have to have it shipped to your home; you can’t pick it up at the store anymore.” Whah?

Well, if you need one more reason to believe that the unintended consequences of SOX really suck (especially for Mac people, it seems), today comes word that SOX may force Apple to charge Mac users for a feature that would otherwise be free. See, Wi-Fi comes in three flavors: 802.11b, g, and n, each respectively faster. The “n” standard is still a draft, but it’s almost complete. Apple has been shipping computers with unadvertised “n” capability that they have left dormant. That is, you buy a notebook with what you think is just a “g” Wi-Fi card and three months later, when the standard gets ratified, Apple sends you a software update that unlocks it into an “n”. Voila, surprise instant upgrade and a happy customer.

Unfortunately, the word is that Apple will charge $4.99 for the upgrade, which is a suspiciously un-Apple thing to do. iLounge editor Jeremy Horwitz offers an explanation: “Because of the [SOX] Act, the company believes that if it sells a product, then later adds a feature to that product, it can be held liable for improper accounting if it recognizes revenue from the product at the time of sale, given that it hasn’t finished delivering the product at that point. Ridiculous.”

Update: Houman Shadab took this story and ran with it. He posts a great explanation (via iLounge) of how SOX accounting rules could result in the $5 charge. I’m posting it in full after the jump.

I have been working in the software industry for the last 6 years in finance and accounting roles and I have a lot of experience around revenue recognition rules for publicly traded software companies. What Apple is doing is common practice in the industry and is a pain for most product managers because it makes no sense from a customer’s perspective.

There are very specific revenue recognition rules on delivering incomplete and/or promising future updates that provide new features and/or functionality to a product. Based upon how Apple is charging for the “unlocking fee”, it confirms that they began shipping the newer Mac computers before they finalized 802.11n. From a revenue recognition standpoint (remember, we live in a cash based world, but publicly traded companies live in an accrual-based accounting world), there are different ways to account for the decision to ship incomplete hardware to customers and then providing a finished product in the future.

1) Do not charge for 802.11n: This is what everyone probably wanted to hear from Apple, “We are shipping 802.11n enabled hardware, but it will not be ready for X months. Customers who purchase now will be able to enable the hardware with a software update when it becomes available.” If Apple made this commitment to its customers, it would have to defer a portion of the revenue from each unit that ships with the 802.11n cards. Sometimes this amount can be trivial, but based upon Apple’s decision to charge to unlock 802.11n, I would assume the amount was not trivial to them. For example, if we assume that a brand new 802.11n wireless card would cost $100, an auditor would assume the value of providing 802.11n to the customer is worth ~$100. Let’s say a computer costs $2,000, then the company would be able to recognize $1,900 now and then recognize the $100 once the feature has been delivered to the customer. If this happens within the same quarter, it is not a big deal. But if you cross a quarter or multiple quarters, it is can be a big deal. In some EXTREME cases, the auditing firm may say, “Since the wireless card is an integral part of the computer, you’ll have to defer the entire $2,000 until you ship 802.11n.” This is an extreme example, but in some cases, it does apply. (Don’t rationalize it! It’ll make your head spin:)

2) Charge for 802.11n: Do not get this confused with bug releases, patches, and other non-feature releases of a product. There are rules that allow companies to “fix” their products if they are broken, such as security patches to fix critical flaws in your software, bugs, etc, without charging a fee. It is assumed that the product should function and companies are allowed to fix them. BUT, in Apple’s case, they are not providing a hot patch or bug fix, they are providing a new wireless standard that was not complete when you purchased it. So to avoid revenue recognition hell (see above), Apple doesn’t announce that hardware has been shipping with 802.11n hardware and charges customers to activate it once the standards have been finalized. This allows them to avoid deferring a large portion of revenue from their hardware sales, but really sucks for the customers.

This probably sounds all crazy and you probably think I work for Apple (I don’t), but this applies to all software companies: Ever wonder why there are certain windows of time that qualify for free upgrades? Why companies have very odd cross product upgrade paths??? Hahaha! Welcome to the world of publicly traded companies and public accounting!

January 16, 2007 | Comments |

5 comments posted

  1. Posted by: Steve R. - 01/16/2007

    Ridiculous is the attempt of Apple to assign blame for their attempt at price gouging on SOX. Ok the term “price gouging” for a $5 product may be a bit extreme.

    Since I have not studied SOX, nor am I either a lawyer or an accountant - I cannot explicitly refute the connection other than to say that this assertion simply does-not-compute. I would like to see a legitimate discussion of how SOX could be interpreted to apply to this case. But as written, SOX has been thrown out by Apple as a “red-herring”

    Let’s look at the SOX connection based on recent news stories. Apple claims that it has to impose this onerous user charge on SOX. Yet Apple ignores SOX for other corporate activities.

    Apple proposes to introduce the iPhone and has been sued by CISCO for patent infringement. Introducing a product line that has significant potential liability associated with it, would be a major accounting nightmare.

    According to the Washington Post (Dec. 30, 2006) Apple has admitted to falsifying the approval of 7.5 million stock options. The falsifying of records on its face is illegal, you don’t need a law such as SOX.

    My point, if Apple is willing to pursue questionable business activites involving millions of dollars, that appear not to be legal, why should I believe that they are being “honest” over a $5 item.

  2. Posted by: Jerry Brito - 01/16/2007

    Steve,

    You comment around here a lot, and I appreciate that, but I’d wish you’d be a bit better informed before doing so. First, as all the articles point out, Apple hasn’t said anything yet. This is all speculation, so your claims that Apple s using SOX as a “red herring” are baseless. Second, what does Apple’s actions on any other front (stock options or IP) have to do with its actions on the Wi-Fi charge? Company’s aren’t people, and they don’t have to take internally consistent positions.

    In any event, just to clarify your IP point, Cisco has not sued Apple for patent infringement; it has sued for trademark infringement. This is more than a semantic quibble. I’m sure Apple knew what it was doing by using the iPhone name. It felt pretty comfortable either that a) Cisco had abandoned its trademark, or b) it’s product is sufficiently different to use the same name without violating the trademark.

    Cheers,
    JB

  3. Posted by: Don Marti - 01/16/2007

    In the magazine business, you sell a subscription, send the first issue, get paid, and then send the remaining issues. You don’t have to bill as you go. What you do have to do is put the money for the un-sent issues in a subscription escrow account. Sarbanes-Oxley didn’t change this.

    If a vendor really takes the position that they can’t recognize the revenue until the feature works, that’s no reason to bother the user at upgrade time — they can always put the cost of the feature aside in a separate account and recognize it later.

  4. Posted by: Steve R. - 01/16/2007

    Thank you for responding.
    First, I stated in my prior post that I could not expressly refute the possible legitimacy of the claim that SOX could “require” Apple to charge “extra” in the name of proper accounting. I also asked that this tenuous connection be explained in greater detail. If this connection can be demonstrated, my “case” dies and I go sulk in a corner for a while.
    Second, talk is cheap. It is easy for Apple to pick some obscure law that many people do not like as an excuse for charging extra rather than admit that they simply want to get an extra $5 for each Mac sold. Accounting is accounting, I simply find it incredulous that a $5 item can somehow cause major accounting issues while back dating stock options does not. Seems like an obvious case of relative reality.

  5. Posted by: Jeremy - 01/16/2007

    SOX makes companies do some pretty stupid things that costs them WAAAAAY more money than Apple could hope to make off this.

    For example, at a Fortune 500 electronics retailer which I just finished a contract with, some IT managers are requiring developers to write word documents to describe each and every line of code they write. Seriously. All so the CIO can review it, supposedly (we’ll see if that happens). They’re spending more time on SOX compliance than actually doing productive work.

    Believe me, I’m no fan of corporate America, but in the case of SOX they have no idea what to do and they’re all really scared of being the next Enron. Besides, Apple charges enough for their macbooks already… when you can basically name your price and have people buy whatever you put in an off white box, I doubt they care much about $4.99.

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