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The Conundrum of iTunes' Recognition of Revenues

An excerpt from a report titled “iTunes Business Review” which I’m currently writing:

Revenue Recognition

Before proceeding it’s also important to understand one more detail: The company does not report all transactions through iTunes as revenue. To quote the 2012 Annual Report (10 K):

For third-party applications sold through the App Store and Mac App Store and certain digital content sold through the iTunes Store, the Company does not determine the selling price of the products and is not the primary obligor to the customer. Therefore, the Company accounts for such sales on a net basis by recognizing in net sales only the commission it retains from each sale. The portion of the gross amount billed to customers that is remitted by the Company to third-party app developers and certain digital content owners is not reflected in the Company’s Consolidated Statements of Operations.

What this means is that App revenues are only reported at the 30% level that is retained by Apple. The 70% paid to developers is excluded from Apple’s financial reports. The same is true for other products for which it considers to be acting as an agent. The difference seems to be mostly in cases where Apple does not define the end user pricing. This is mostly true for ebooks however that may not be true for all book titles.

This distinction between “gross” revenues and “reported” revenues is maintained in this report but both are presented for consideration. Gross revenues are needed for comparing the media businesses against each other and for competitive assessment but reported revenues are needed to test assumptions against ground truth.

This can be explained with an example:

If a song sells for 99c then Apple reports all 99c as Revenue and then pays the record company about 70c and uses 30c to operate the store and pay for transaction costs. In the case of music it means the Gross Revenue is 99c and the Reported Revenue is also 99c.

However, if an app sells for 99c then Apple reports only about 30c as Revenue. It does not consider the portion paid to developers as revenues for itself. It spends a portion of the 30c to pay for transactions, hosting, and the time testing and accepting the apps. In the case of apps and books it means the Gross Revenue is 99c and the Reported Revenue is 30c.

So if Apple sells one song and one app then the Consolidated Gross Revenue is 2 x 99c or $1.98 but the Consolidated Reported Revenue is only $1.29 (99c + 30c).

The difference in accounting is sometimes called “agency” vs. “wholesale” and it applies in some retail businesses. Another term sometimes used for used goods is selling items “on consignment“.

The reasoning for why some media are treated one way or another is cited in the Annual report as “the Company does not determine the selling price of the products and is not the primary obligor to the customer”. In the case of Apps, the price is set by the developer and the developer is obligated to deliver on the promise. Apple acts as transaction processor and they don’t consider that they ever owned (and hence never sold) the app. Note that this accounting is probably discretionary. They decided to do it this way and it’s not clear that it was necessary to do it this way by any regulation.

This distinction between two treatments of revenue makes it difficult to understand the complete story behind iTunes.

If you’re interested in the full report, contact me directly.

UPDATE:

Apple’s rationale can be partly justified from a reading of a Financial Accounting Standards Board statement titled “Reporting Revenue Gross as a Principal versus Net as an Agent” (Emerging Issues Task Force Abstract EITF 99-19 http://www.fasb.org/pdf/abs99-19.pdf) a portion of which is quoted below.

“Indicators of Net Revenue Reporting

15. The supplier (not the company) is the primary obligor in the arrangement— Whether a supplier or a company is responsible for providing the product or service desired by a customer is a strong indicator of the company’s role in the transaction. If a supplier (and not the company) is responsible for fulfillment, including the acceptability of the product(s) or service(s) ordered or purchased by a customer, that fact may indicate that the company does not have risks and rewards as principal in the transaction and that it should record revenue net based on the amount retained (that is, the amount billed to the customer less the amount paid to a supplier). Representations (written or otherwise) made by a company during marketing and the terms of the sales contract generally will provide evidence as to a customer’s understanding of whether the company or the supplier is responsible for fulfilling the ordered product or service.

 

  • JonathanU

    I would love to know your projections for the next 36 months for iTunes revenue growth.

  • stsk

    Interesting, but puzzling. I can’t, off the top of my head, think of a good reason for accounting this way, unless it’s an artifact of music-industry practice. A company has some leeway in how to account for licensing revenue from IP. (note, there are no “sales” in the case of either music or software, so the “agency vs wholesale” precedents are a bit off the mark.) Since the company has discretion, accounting practice depends on how the company wants to show the results of the accounting. e.g. if a company needs to show higher gross margins, it will use an “agency” accounting method, realizing nearly total profit from each “sale”. If said company wants to show higher revenue at the expense of margin it will show the full “revenue” of each sale. There are almost no incremental COGS (cost of goods sold) associated with licensing IP, which creates this accounting “opportunity”. Apple seems to be using both, but I don’t know why.

    • MOD

      I agree. Its choice could be used to manage either GP margin or the total revenues figure. Doing both does not make much sense.

      But to be honest some of Apple’s financial choices do not make sense: cash management, earnings guidance, ROI on its lawsuits. I don’t think Oppenheimer is the best qualified CFO.

      I don’t see how delivering electronic music is different from delivering electronic software.
      I predict reporting will become uniform in the future.
      Likely in the direction of the net model. Apple does not guarantee the songs
      if customers do not like them, nor is in a position to give refunds.
      And its inventory is laughable: only one copy of each.

      It is very much more like a broker than a retailer.

      This EITF (Emerging Issue Task Force) does give wide latitude to interpretation.

      http://www.fasb.org/cs/BlobServer?blobkey=id&blobwhere=1175820914023&blobheader=application%2Fpdf&blobcol=urldata&blobtable=MungoBlobs

  • benbajarin

    I used to work with a company that had as robust an online store music library as iTunes did at the time. This was a few years ago. This company had to pay the labels up front for the rights to have their songs in their online store. There was an upfront license fee plus a revenue sharing structure. This is standard industry practice and I am willing to bet Apple has had and still has to do the same thing. So it would make sense that part of the reason they claim the 99c is because they had to shell out costs in order to offer the digital library in the first place.

    Its a theory at least.

  • http://twitter.com/bennomatic bennomatic

    I’m sure it’s a question of predictability. With music, pricing is fairly uniform and cycles can be tracked and predicted. With apps, it’s probably less so. Nobody at Apple knew that Brichter’s Letterpress app was coming, nor that it would sell so many copies that GameCenter would effectively be shut down.

    With so much scrutiny on their numbers–the stock seems to go down if they’re too far off in either direction–I’m sure Apple would prefer to predict, say $300M in revenues from app sales and be off by $150M than $1B in revenues from app sales and be off by $500M. It’s 50% either way, but this reporting scheme reduces the instability of this one set of variables.

  • Noah Berlove

    So what Apple is saying is that they “determine the selling price” and are the “primary obligor to the customer” for traditional iTunes content (i.e. music).

    • http://twitter.com/asymco Horace Dediu

      Yes.

  • Trip

    I’m curious to hear opinions on this BGR article, discussing the opty for Apple to use iTunes for more general purchases. http://bgr.com/2013/03/19/apple-mobile-payments-analysis-itunes-371912/?utm_source=trending-widget&utm_medium=home

  • Rogers

    The reason Apple does it this way is very straight-forward: They care more about the platform/ecosystem than the sales. (Compare to Amazon.) Apple displays this attitude in many different ways.

    What’s good about the model … the Agent: doesn’t determine pricing (pro Producer); avoids legal liability (warranty, refunds, complying with local laws regulations for content); may be required in certain jurisdictions (e.g., Japan, etc.). Plus the Producers love it: they control pricing; full revenue recognition; more. The accounting is required by the model they choose.

    Strength of Agency model: Producers can’t buy access. Agents can’t lower prices unilaterally. Agents can focus on the end-user, editorialize and curate.

  • Chaka10

    Thanks for doing this important analysis. Look forward to the report when you complete it. Thanks also for the clarification on the FASB accounting rules. Revenue recognition is actually fairly well known to be a thicket for somewhat less than scrupulous financial reporting (it can matter a lot to businesses trying to show top-line growth — recall the dot com boom 1.0, when a lot of companies were valued on revenue multiples…). Apple’s appears to be taking a conservative approach on revenue recognition for its “agency” businesses.

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