Technology

A Worm in the Apple


The computer and iPod maker's expanded investigation of improper stock options may result in dramatically revised earnings

Apple Computer (AAPL) warned late Thursday that it would be restating some of its earnings going back to 2002, as part of an investigation into improper accounting for stock options given to employees. The company also said it would delay the announcement of earnings for the quarter ended July 1.

The warning was the latest development in a matter first disclosed on June 29. At that time, the company said that it had uncovered irregularities with stock options awarded to employees between 1997 and 2001, including one award to Chief Executive Steve Jobs. The company also appointed an independent counsel to investigate the matter (see BusinessWeek.com, 6/29/06, "Apple's 'Irregular' Options").

WIDENING SCOPE.

Now the investigation into possible wrongdoing at the Silicon Valley stalwart is widening to include the past four years. Apple said in a release that it had uncovered "additional evidence of irregularities" and that it will likely have to restate financial statements and take "noncash charges" for employee compensation. The company said it could not yet determine the extent of the charges or the tax implications. It advised investors not to rely on financial statements and earnings-related press releases going back to Sept. 29, 2002. Apple's stock tumbled 7% in after-market trading, to $65.

If the restatements turn out to be serious, it would cast a pall over one of the most impressive business comebacks in American corporate history. Steve Jobs, one of the company's original founders, returned to Apple and restored it to the glory it enjoyed at the dawn of the PC era. This time, he has done it by making the company's wildly successful iPod the icon of the digital media revolution.

The period specified in the Aug. 3 warning covers the years that the iPod has risen to mass popularity. In 2002, the music player was first made available to consumers using computers running Microsoft's (MSFT) Windows operating system. That greatly expanded the potential market, triggering sales growth that soon became the envy of an entire industry. It also ultimately put Jobs and Apple at the center of the new digital media world, with record companies, Hollywood studios, and thousands of podcasters all scrambling to win favor with Apple.

Some of the years when Apple showed lean profits—specifically its fiscal years 2002 and 2003—would appear to be at risk of becoming loss-making years. Apple had reported a $65 million profit on sales of $3.2 billion for fiscal 2002 and a $69 million profit on sales of $3.6 billion for 2003. Profits swelled to $276 million in 2004 and $1.3 billion in 2005, propelled by staggering iPod sales and a recovery of the market for its Macintosh personal computers.

BACKDATING SCANDALS.

The controversy over the backdating of stock options has spread rapidly in recent months. It has touched more than 60 companies, including tech players such as Broadcom (BRCM), CNET Networks (CNET), Juniper Networks (JNPR), McAfee (MFE), Rambus (RMBS), and RSA Security (RSAS). The disclosure of options troubles has sent many of the companies' stocks tumbling, and at least two of the companies involved, Mercury Interactive (MERQ) and M-Systems (FLSH), agreed to be acquired after their disclosures (see BusinessWeek.com, 8/1/06, "From Options Backdaters to M&A Targets").

Stock options usually give employees the opportunity to buy a number of shares at a price approved by the company's board of directors at the time of issue. Employees can then realize gains from exercising their options, if the stock rises above the price at which the options were issued. Backdating, however, is when the company pushes back the grant date for the options to some time in the past, when the stock price is lower than the price on the true day of issue. The practice can give executives immediate risk-free profits, undermining the argument that options provide an incentive for managers to turn in a strong performance. It can also result in the misstatement of employee compensation costs and company profits, and it may have tax implications.

The company has not specified which of the stock options given to Jobs are in question. However, in one case in 2000, the chief executive was granted options on 20 million shares, Securities & Exchange Commission filings show. Then in 2003, he voluntarily canceled 27.5 million options as part of a companywide effort to reduce the number of outstanding options, according to a press release at the time. The canceled options resulted in "no financial gain to the CEO," Apple said.

Hesseldahl is a senior writer for BusinessWeek.com and his Byte of the Apple column, covering all things Apple, appears biweekly at http://www.businessweek.com/technology/.

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