Accounting rules change could end iPod touch update fee

As much as prospective iPod touch owners might want camera or GPS hardware, nothing seems to draw their ire more than being charged for iPhone OS updates—especially when iPhone users get them for free. Proposed accounting rule changes will let Apple finally record iPhone revenues all at once in the quarter in which it is earned without resorting to spreading it out over two years. This is all fine and good for Apple, but the same rule changes may also allow Apple to nix the fee that iPod touch owners are charged every time Apple releases a major update to its mobile operating system.

Here's what has been happening up to this point. Apple wanted to offer iPhone users free software updates. According to a reading of certain accounting rules relating to the Sarbanes-Oxley Act, items that gain significant new functionality after the sale—due to a firmware update, for instance—can't have the revenue recorded at the time of sale. The revenue is reported over a certain period of time, called subscription accounting. Since Apple planned to potentially offer new features in software updates, it records revenue from the sale if iPhones over a period of two years—the length of a standard carrier contract.

The reverse of this accounting happens for the iPod touch. Apple didn't want to stop reporting the revenue earned from sales of the iPod touch, possibly since Apple was aware it could start to eat into the revenue from click-wheel iPods. Since the company wanted to be able to report the revenue from all iPod sales all at once, Apple couldn't add significant new features to the iPod touch without charging some fee. When iPhone OS 1.1.3, 2.0 and 3.0 came out, iPod touch users who wanted to upgrade had to fork ever some dough—first $20 for 1.1.3, then $10 for 2.0 or 3.0; upgrading straight to 3.1 now only costs $5.

Apple isn't the only company that has been lobbying to change this rule—other companies like Microsoft and Xerox also have to deal with it in one form or another. However, Apple ended up having to report two sets of figures for its quarterly and yearly earnings reports: GAAP (generally accepted accounting principles) earnings, using the subscription revenue for iPhones, and non-GAAP earnings, which include the full revenue from iPhone sales. Needless to say, Apple would prefer to report the non-GAAP numbers, since it is a more accurate representation of the company's performance in a given quarter.

"It is our belief that investors, analysts and preparers would benefit significantly from the proposed changes," wrote Apple VP Betsy Rafael in a letter to the Financial Accounting Standards Board. "[The current rule] often results in accounting that does not reflect the underlying economics of transactions and can result in financial reporting that lacks the transparency necessary to fully inform users making investment decisions."

Thanks to lobbying by Apple and other tech companies, the FASB has tentatively approved changes to the rules that could make subscription accounting a thing of the past. The change would have an immediate impact on Apple's revenue reporting, and could significantly boost its stock price if investors could get a true picture of the impact of the iPhone on Apple's bottom line.

That change also means that Apple could be free to offer major iPhone OS updates to iPod touch users completely free of charge. It would save Apple the hassle of getting millions of hits on its iTunes servers—not to mention millions of additional credit card transaction fees—whenever an update is released. But it would also save iPod touch owners the perceived sting of paying for an update that others get for free. Additionally, it would encourage faster adoption of iPhone OS updates, thereby making it easier for developers to target features found only in newer versions of the OS.

While the accounting and revenue reporting headaches—and possible boost to AAPL—is a significant advantage of this rule change, we thing the goodwill Apple would earn from free iPod touch OS updates would be incalculable.