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Apple 10-Q 2006

Documents found in this filing:

  1. 10-Q
  2. Ex-10.B.20
  3. Ex-31.1
  4. Ex-31.2
  5. Ex-32.1
  6. Ex-32.1

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-Q


 

(Mark One)

x                                QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended July 1, 2006

 

or

o                                   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                            to                            .

 

Commission File Number: 000-10030


APPLE COMPUTER, INC.

(Exact name of registrant as specified in its charter)

CALIFORNIA

 

942404110

(State or other jurisdiction

 

(I.R.S. Employer Identification No.)

of incorporation or organization)

 

 

 

 

 

1 Infinite Loop
Cupertino, California

 

95014

(Address of principal executive offices)

 

(Zip Code)

 

Registrant’s telephone number, including area code: (408) 996-1010


Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer x

 

Accelerated filer o

 

Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No x

859,273,757 shares of common stock issued and outstanding as of December 13, 2006

 




Explanatory Note

In this Form 10-Q, Apple Computer, Inc. (“Apple” or “the Company”) is restating its condensed consolidated balance sheet as of September 24, 2005, the related consolidated statements of operations for the three and nine months ended June 25, 2005, and the related consolidated statement of cash flows for the nine months ended June 25, 2005.  In the Company’s Form 10-K for the year ended September 30, 2006 to be filed with the Securities and Exchange Commission (the “2006 Form 10-K”), the Company is restating its consolidated balance sheet as of September 24, 2005, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the fiscal years ended September 24, 2005 and September 25, 2004, and each of the quarters in fiscal year 2005.

The Company’s 2006 Form 10-K also reflects the restatement of “Selected Consolidated Financial Data” in Item 6 for the fiscal years ended September 2005, 2004, 2003, and 2002, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 for the fiscal years ended September 24, 2005 and September 25, 2004.

Previously filed annual reports on Form 10-K and quarterly reports on Form 10-Q affected by the restatements have not been amended and should not be relied on.

On June 29, 2006, the Company announced that an internal review had discovered irregularities related to the issuance of certain stock option grants made between 1997 and 2001, including a grant to its Chief Executive Officer (“CEO”) Steve Jobs.  The Company also announced that a Special Committee of outside directors (“Special Committee”) had been formed and had hired independent counsel to conduct a full investigation of the Company’s past stock option granting practices.  On October 4, 2006, the Company announced the key results of the Special Committee’s investigation, which are set forth in the Company’s Form 8-K filed on that date.

As a result of the internal review and the independent investigation, management has concluded, and the Audit and Finance Committee of the Board of Directors agrees, that incorrect measurement dates were used for financial accounting purposes for certain stock option grants made in prior periods.  Therefore, the Company has recorded additional non-cash stock-based compensation expense and related tax effects with regard to past stock option grants, and the Company is restating previously filed financial statements in this Form 10-Q and the 2006 Form 10-K.  These adjustments, after tax, amounted to $4 million, $7 million, and $10 million in fiscal years 2006, 2005 and 2004, respectively.  The adjustment to 2006 was recorded in the fourth quarter of fiscal year 2006 due to its insignificance.

The independent counsel and its forensic accountants (“Investigative Team”) reviewed the facts and circumstances surrounding stock option grants made on 259 dates. The Investigative Team spent over 26,500 person-hours searching more than one million physical and electronic documents and interviewing more than 40 current and former directors, officers, employees, and advisors.  Based on a review of the totality of evidence and the applicable law, the Special Committee found no misconduct by current management. The Special Committee’s investigation identified a number of grants for which grant dates were intentionally selected in order to obtain favorable exercise prices.  The terms of these and certain other grants, as discussed below, were finalized after the originally assigned grant dates.  The Special Committee concluded that the procedures for granting, accounting for, and reporting stock option grants did not include sufficient safeguards to prevent manipulation. Although the investigation found that CEO Steve Jobs was aware or recommended the selection of some favorable grant dates, he did not receive or financially benefit from these grants or appreciate the accounting implications. The Special Committee also found that the investigation had raised serious concerns regarding the actions of two former officers in connection with the accounting, recording and reporting of stock option grants.

Based on the evidence and findings from the Company’s internal review and the Special Committee’s independent investigation, an analysis was performed of the measurement dates for the 42,077 stock option grants made on 259 dates between October 1996 and January 2003 (the “relevant period”). The Company believes that the analysis was properly limited to the relevant period. In addition to analyzing all grants made during the relevant period, the Company sampled certain grants between 1994 and 1997 and found none that required accounting adjustments. The first grants for which stock-based compensation expense is required are dated December 29, 1997. The Company also examined grants made after the relevant period and found none that required accounting adjustments. 

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Moreover, in the years after 2002, Apple made significant changes in its stock option granting practices in response to evolving legal, regulatory and accounting requirements.

Consistent with the accounting literature and recent guidance from the Securities and Exchange Commission (“SEC”), the grants during the relevant period were organized into categories based on grant type and process by which the grant was finalized. The Company analyzed the evidence related to each category of grants including, but not limited to, electronic and physical documents, document metadata, and witness interviews.  Based on the relevant facts and circumstances, the Company applied the controlling accounting standards to determine, for every grant within each category, the proper measurement date.  If the measurement date is not the originally assigned grant date, accounting adjustments were made as required, resulting in stock-based compensation expense and related tax effects.

The 42,077 grants were classified as follows: (1) 17 grants to persons elected or appointed to the Board of Directors (“director grants”); (2) 3,892 grants to employees under the Monday/Tuesday Plan described below (“Monday/Tuesday grants”); (3) 27,096 grants made in broad-based awards to large numbers of employees, usually on an annual basis (“focal grants”); (4) 9,988 other grants ratified at meetings of the Board or Compensation Committee (“meeting grants”); (5) 1,082 other grants ratified by unanimous written consent (“UWC”) of the Board or Compensation Committee (“other UWC grants”); and (6) two grants to the CEO (“CEO grants”).  All references to the number of option shares, option exercise prices and share prices in this Explanatory Note have not been adjusted for any subsequent stock splits.

With the exception of director grants, all stock option grants were subject to ratification by the Board or Compensation Committee at a meeting or by UWC.  Following approval of the grants at a meeting or by UWC, the Company’s legal staff would prepare a Secretary’s Certificate certifying the ratification of the grants.  Based on the facts and circumstances described below, the Company has concluded that the recipients and terms of certain grants were fixed for accounting purposes before ratification pursuant to parameters previously approved by the Board or Compensation Committee through the Monday/Tuesday Plan and the focal process.  As further discussed below, within these parameters, management had the authority to determine the recipients and terms for each grant.  Thus, the Company has concluded that the measurement dates for these grants occurred when management’s process for allocating these grants was completed and the grants were ready for ratification, which was considered perfunctory.  With regard to all other grants, the Company has concluded that the grants were finalized and the measurement dates occurred when the grants were ratified.  For many grants, however, the dates of ratification cannot be established because the dates the UWCs were executed by the Board or Compensation Committee members or received by the Company are not available.  For such grants, the Company has concluded that the date of the preparation of the Secretary’s Certificate is the best alternative for determining the actual date of ratification.

As discussed below, the Company’s analysis determined that the originally assigned grant dates for 6,428 grants on 42 dates are not the proper measurement dates.  Accordingly, after accounting for forfeitures, the Company has recognized stock-based compensation expense of $105 million on a pre-tax basis over the respective awards’ vesting terms. No adjustments were required for the remaining 35,649 grants.  The adjustments were determined by category as follows:

Director Grants – Seventeen director grants were made during the relevant period.  Two director grants were made pursuant to a 1997 plan that dated the grants on the enactment of the plan.  The remaining fifteen grants were automatically made under the Director Stock Option Plan for non-employee directors, which was approved by shareholders in 1998, on the date of a director’s election or appointment to the Board and on subsequent anniversaries, beginning on the fourth anniversary.  Accordingly, the analysis determined that the originally assigned grant date for each director grant is the measurement date, and no accounting adjustments are required.

Monday/Tuesday Grants – Beginning in December 1998, 3,892 new hire grants and grants for promotion and retention purposes (“promotion/retention grants”) were made during the relevant period under the “Monday/Tuesday Plan.”  Under the Monday/Tuesday Plan, new hire grants made within pre-established guidelines approved by the Board or Compensation Committee were dated on the Monday that the recipient started work (or the following Monday, if the recipient started on another day). The Company’s analysis showed this process to be reliable with very low error rates.  Promotion/retention grants, also based on pre-established guidelines, were made generally on the first Tuesday of each month. The Company has concluded that the new hire and promotion/retention grants made

3




pursuant to the Monday/Tuesday Plan within pre-established guidelines do not require adjustment, with the exception of six grants that were erroneously dated before the employees’ start dates. For 120 new hire and promotion/retention grants made outside the guidelines, however, the Company has concluded that the measurement dates are the dates of ratification by the Board or Compensation Committee rather than the dates used for grants within guidelines.  Accordingly, based on the methodology described above, the Company has recognized stock-based compensation expense of $6 million from 126 grants.  If other dates in the period between the preparation of the UWC and the preparation of the Secretary’s Certificate had been used as measurement dates for grants whose actual ratification dates are unknown, the total stock-based compensation expense would have ranged from approximately $3 million to $7 million.

Focal Grants – During the relevant period, 27,096 focal grants were made to employees typically on an annual basis as part of an extensive process that required several months to complete. Pursuant to limits, guidelines and practices previously approved by the Board or Compensation Committee, managers throughout the Company would make recommendations for grants to employees in their areas of responsibility.  After senior management had determined that the grants were made in accordance with these established limits, guidelines and practices, management treated the grants as final when they were submitted to the Board or Compensation Committee for ratification.  The Company has concluded that for 5,595 grants on five dates, the originally assigned grant dates are not the proper measurement dates.  For these grants, management’s process for finalizing the grants was completed after the originally assigned grant dates.  As a result, the Company has recognized $29 million of stock-based compensation expense.  For two of the five grant dates comprising 3,744 grants, the evidence shows that the grants were finalized and the measurement date occurred one day after the originally assigned grant dates.  The grants on these two dates represent more than $16 million of the total $29 million of stock-based compensation expense resulting from focal grants.

Other Meeting Grants – During the relevant period, meetings of the Board or Compensation Committee were held to ratify 9,988 grants that are not Monday/Tuesday, focal or CEO grants. The grant dates and measurement dates for these grants are the meeting dates when the grants were ratified, with the exception of 46 grants.   Forty-two of these 46 grants are dated concurrent with a meeting that considered and approved certain grants, but the evidence indicates that all of the grants may not have been finalized until a later date.  One of the 46 grants was approved and dated at another meeting, but the recipient, who was becoming employed by the Company as part of a corporate acquisition, did not start until a later date. Two other grants were approved before the employees’ start dates.  Another grant was mistakenly cancelled and subsequently reinstated, requiring an accounting adjustment. Thus, for these 46 grants the Company has concluded that the originally assigned grant dates are not the proper measurement dates.  As a result, the Company has recognized $2 million of stock-based compensation expense.

Other UWC Grants – During the relevant period, 1,082 grants were approved by UWCs for a variety of purposes, including executive recruitment, retention, promotion and new hires outside the Monday/Tuesday process. These grants were not made pursuant to pre-established guidelines adopted by the Board or Compensation Committee. Therefore, the Company has concluded that these grants were not finalized for accounting purposes until ratification by the Board or Compensation Committee. Accordingly, for 660 grants, the Company has concluded that the originally assigned grant dates are not the proper measurement dates. As a result, the Company has recognized $48 million of stock-based compensation expense. If other dates in the period from the preparation of the UWC to the preparation of the Secretary’s Certificate had been used as measurement dates for grants whose actual ratification dates are unknown, the total stock-based compensation would have ranged from approximately $35 million to $56 million.

CEO Grants – During the relevant period, the Company made two grants to CEO Steve Jobs.  The first grant, dated January 12, 2000, was for 10 million option shares.  The second grant, dated October 19, 2001, was for 7.5 million option shares. Both grants were cancelled in March 2003 prior to being exercised, when Mr. Jobs received 5 million shares of restricted stock.

With respect to the grant dated January 12, 2000, the Board on December 2, 1999, authorized a special “CEO Compensation Committee” to grant Mr. Jobs up to 15 million shares.  The evidence indicates that the CEO Compensation Committee finalized the terms of the grant on January 12, 2000, although the Committee’s action was memorialized in a UWC transmitted on January 18, 2000. Because the measurement date is the originally assigned grant date, the Company has not recognized any stock-based compensation expense from this grant. If the Company had determined

4




that the measurement date was the date when the UWC was executed or received, then additional stock-based compensation would have been recognized.

The grant dated October 19, 2001 was originally approved at a Board meeting on August 29, 2001, with an exercise price of $17.83.  The terms of the grant, however, were not finalized until December 18, 2001.  The grant was dated October 19, 2001, with an exercise price of $18.30.  The approval for the grant was improperly recorded as occurring at a special Board meeting on October 19, 2001.  Such a special Board meeting did not occur.  There was no evidence, however, that any current member of management was aware of this irregularity.  The Company has recognized $20 million in stock-based compensation expense for this grant, reflecting the difference between the exercise price of $18.30 and the share price on December 18, 2001 of $21.01.

The incremental impact from recognizing stock-based compensation expense resulting from the investigation of past stock option grants is as follows (dollars in millions):

Fiscal Year

 

Pre-Tax Expense (Income)

 

After Tax Expense

 

 

 

 

 

 

 

1998

 

$

(1

)

$

 

1999

 

8

 

6

 

2000

 

13

 

9

 

2001

 

19

 

13

 

2002

 

29

 

23

 

2003

 

16

 

12

 

2004

 

13

 

10

 

2005

 

7

 

7

 

2006

 

1

 

4

 

 

 

 

 

 

 

Total

 

$

105

 

$

84

 

 

Additionally, the Company has restated the pro forma expense under Statement of Financial Accounting Standards (“SFAS”) No. 123 in Note 1 of the Notes to Condensed Consolidated Financial Statements of this Form 10-Q and in Note 1 of the Notes to Consolidated Financial Statements of the 2006 Form 10-K to reflect the impact of these adjustments.

5




PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

APPLE COMPUTER, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)
(in millions, except share and per share amounts)

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

July 1,
2006

 

June 25,
2005

 

July 1,
2006

 

June 25,
2005

 

 

 

 

 

As Restated (1)

 

 

 

As Restated (1)

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

$

4,370

 

$

3,520

 

$

14,478

 

$

10,253

 

Cost of sales (2)

 

3,045

 

2,476

 

10,292

 

7,246

 

Gross margin

 

1,325

 

1,044

 

4,186

 

3,007

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Research and development (2)

 

175

 

145

 

533

 

388

 

Selling, general, and administrative (2)

 

584

 

473

 

1,808

 

1,393

 

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

759

 

618

 

2,341

 

1,781

 

 

 

 

 

 

 

 

 

 

 

Operating income

 

566

 

426

 

1,845

 

1,226

 

 

 

 

 

 

 

 

 

 

 

Other income and expense

 

95

 

46

 

252

 

105

 

 

 

 

 

 

 

 

 

 

 

Income before provision for income taxes

 

661

 

472

 

2,097

 

1,331

 

 

 

 

 

 

 

 

 

 

 

Provision for income taxes

 

189

 

153

 

650

 

431

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

472

 

$

319

 

$

1,447

 

$

900

 

 

 

 

 

 

 

 

 

 

 

Earnings per common share:

 

 

 

 

 

 

 

 

 

Basic

 

$

0.55

 

$

0.39

 

$

1.72

 

$

1.12

 

Diluted

 

$

0.54

 

$

0.37

 

$

1.65

 

$

1.05

 

 

 

 

 

 

 

 

 

 

 

Shares used in computing earnings per share (in thousands):

 

 

 

 

 

 

 

 

 

Basic

 

851,375

 

815,092

 

840,759

 

804,098

 

Diluted

 

876,368

 

860,803

 

876,971

 

853,238

 

 


(1) See Note 2, “Restatement of Condensed Consolidated Financial Statements,” in Notes to Condensed Consolidated Financial Statements.

(2) Includes stock-based compensation expense, which was allocated as follows:

Cost of sales

 

$

6

 

$

 

$

16

 

$

2

 

Research and development

 

$

12

 

$

2

 

$

40

 

$

5

 

Selling, general, and administrative

 

$

19

 

$

10

 

$

67

 

$

30

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

6




APPLE COMPUTER, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)
(in millions, except share amounts)

 

 

July 1, 2006

 

September 24, 2005

 

 

 

 

 

As Restated (1)

 

ASSETS:

 

 

 

 

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

8,013

 

$

3,491

 

Short-term investments

 

1,163

 

4,770

 

Accounts receivable, less allowances of $51 and $46, respectively

 

1,089

 

895

 

Inventories

 

213

 

165

 

Deferred tax assets

 

491

 

331

 

Other current assets

 

1,522

 

648

 

Total current assets

 

12,491

 

10,300

 

Property, plant, and equipment, net

 

1,197

 

817

 

Goodwill

 

38

 

69

 

Acquired intangible assets, net

 

37

 

27

 

Other assets

 

1,351

 

303

 

Total assets

 

$

15,114

 

$

11,516

 

 

 

 

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY:

 

 

 

 

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

2,513

 

$

1,779

 

Accrued expenses

 

2,510

 

1,708

 

Total current liabilities

 

5,023

 

3,487

 

Non-current liabilities

 

761

 

601

 

Total liabilities

 

5,784

 

4,088

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

Common stock, no par value; 1,800,000,000 shares authorized;
852,987,629 and 835,019,364 shares issued and outstanding, respectively

 

4,249

 

3,564

 

Deferred stock compensation

 

 

(61

)

Retained earnings

 

5,065

 

3,925

 

Accumulated other comprehensive income

 

16

 

 

Total shareholders’ equity

 

9,330

 

7,428

 

Total liabilities and shareholders’ equity

 

$

15,114

 

$

11,516

 

 


(1) See Note 2, “Restatement of Condensed Consolidated Financial Statements,” in Notes to Condensed Consolidated Financial Statements.

See accompanying Notes to Condensed Consolidated Financial Statements.

7




APPLE COMPUTER, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(in millions)

 

 

Nine Months Ended

 

 

 

July 1, 2006

 

June 25, 2005

 

 

 

 

 

As Restated (1)

 

 

 

 

 

 

 

Cash and cash equivalents, beginning of the period

 

$

3,491

 

$

2,969

 

 

 

 

 

 

 

Operating Activities:

 

 

 

 

 

Net income

 

1,447

 

900

 

Adjustments to reconcile net income to cash generated by operating activities:

 

 

 

 

 

Depreciation, amortization, and accretion

 

159

 

128

 

Stock-based compensation expense

 

123

 

37

 

Provision for deferred income taxes

 

201

 

 

Excess tax benefits from stock options

 

 

279

 

Gain on sale of PowerSchool net assets

 

(4

)

 

Loss on disposition of property, plant, and equipment

 

5

 

6

 

Changes in operating assets and liabilities:

 

 

 

 

 

Accounts receivable

 

(194

)

(53

)

Inventories

 

(48

)

(92

)

Other current assets

 

(880

)

(11

)

Other assets

 

(1,113

)

(17

)

Accounts payable

 

734

 

79

 

Other liabilities

 

735

 

527

 

Cash generated by operating activities

 

1,165

 

1,783

 

Investing Activities:

 

 

 

 

 

Purchases of short-term investments

 

(4,393

)

(7,624

)

Proceeds from maturities of short-term investments

 

7,827

 

5,108

 

Proceeds from sales of short-term investments

 

175

 

582

 

Purchases of long-term investments

 

(12

)

 

Proceeds from sale of PowerSchool net assets

 

40

 

 

Purchases of property, plant, and equipment

 

(512

)

(164

)

Other

 

(39

)

(29

)

Cash generated by (used for) investing activities

 

3,086

 

(2,127

)

Financing Activities:

 

 

 

 

 

Proceeds from issuance of common stock

 

286

 

469

 

Excess tax benefits from stock-based compensation

 

339

 

 

Repurchases of common stock

 

(354

)

 

Cash generated by financing activities

 

271

 

469

 

Increase in cash and cash equivalents

 

4,522

 

125

 

Cash and cash equivalents, end of the period

 

$

8,013

 

$

3,094

 

 

 

 

 

 

 

Supplemental cash flow disclosure:

 

 

 

 

 

 

 

 

 

 

 

Cash paid for income taxes, net

 

$

108

 

$

108

 

 


(1) See Note 2, “Restatement of Condensed Consolidated Financial Statements,” in Notes to Condensed Consolidated Financial Statements.

See accompanying Notes to Condensed Consolidated Financial Statements.

8




APPLE COMPUTER, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited)

Note 1 - Summary of Significant Accounting Policies

Apple Computer, Inc. and its wholly-owned subsidiaries (“Apple” or “the Company”) designs, manufactures, and markets personal computers and related software, services, peripherals, and networking solutions.  The Company also designs, develops, and markets a line of portable digital music players along with related accessories and services including the online sale of third-party audio and video products.  The Company sells its products worldwide through its online stores, its retail stores, its direct sales force, and third-party wholesalers, resellers, and value-added resellers.  In addition, the Company sells a variety of third-party Macintosh and iPod compatible products including application software, printers, storage devices, speakers, headphones, and various other accessories and supplies through its online and retail stores.  The Company sells to education, consumer, creative professional, business, and government customers.

Basis of Presentation and Preparation

The accompanying condensed consolidated financial statements include the accounts of the Company.  Intercompany accounts and transactions have been eliminated. The preparation of these condensed consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in these condensed consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates. Certain prior year amounts in the consolidated financial statements and notes thereto have been reclassified to conform to the current year presentation.

These condensed consolidated financial statements and accompanying notes should be read in conjunction with the Company’s annual consolidated financial statements and the notes thereto for the fiscal year ended September 30, 2006, included in the 2006 Annual Report on Form 10-K to be filed with the Securities and Exchange Commission  (the “2006 Form 10-K”).

Typically, the Company’s fiscal year ends on the last Saturday of September. Fiscal year 2005 was a 52-week year. However, approximately every six years, the Company reports a 53-week fiscal year to align its fiscal quarters with calendar quarters by adding a week to its first fiscal quarter. The Company added this additional week in the first fiscal quarter of its fiscal year 2006.  Unless otherwise stated, references to particular years or quarters refer to the Company’s fiscal years ended in September and the associated quarters of those fiscal years.

Software Development Costs

Research and development costs are generally expensed as incurred.  Development costs of computer software to be sold, leased, or otherwise marketed are subject to capitalization beginning when a product’s technological feasibility has been established and ending when a product is available for general release to customers pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 86, Computer Software to be Sold, Leased, or Otherwise Marketed. In most instances, the Company’s products are released soon after technological feasibility has been established. Therefore, costs incurred subsequent to achievement of technological feasibility are usually not significant, and generally all software development costs have been expensed as incurred.

In 2004, the Company began incurring substantial development costs associated with Mac OS X version 10.4 Tiger (“Tiger”) subsequent to achievement of technological feasibility as evidenced by public demonstration in August 2004 and the subsequent release of a developer beta version of the product. During the first nine months of 2005, the Company capitalized $29.7 million of costs associated with the development of Tiger.  In accordance with SFAS No. 86, amortization of this asset to cost of sales began in April 2005 when the Company started shipping Tiger and is being recognized on a straight-line basis over a three-year estimated useful life.

Stock-Based Compensation

On September 25, 2005, the Company adopted SFAS No. 123 (revised 2004) (“SFAS No. 123R”), Share-Based Payment, which addresses the accounting for stock-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair

9




value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. In January 2005, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 107, which provides supplemental implementation guidance for SFAS No. 123R. SFAS No. 123R eliminates the ability to account for stock-based compensation transactions using the intrinsic value method under Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and instead generally requires that such transactions be accounted for using a fair-value-based method.  The Company uses the Black-Scholes-Merton (“BSM”) option-pricing model to determine the fair-value of stock-based awards under SFAS No. 123R, consistent with that used for pro forma disclosures under SFAS No. 123, Accounting for Stock-Based Compensation. The Company has elected to use the modified prospective transition method as permitted by SFAS No. 123R and accordingly prior periods have not been restated to reflect the impact of SFAS No. 123R.  The modified prospective transition method requires that stock-based compensation expense be recorded for all new and unvested stock options, restricted stock, restricted stock units, and employee stock purchase plan shares that are ultimately expected to vest as the requisite service is rendered beginning on September 25, 2005, the first day of the Company’s fiscal year 2006. Stock-based compensation expense for awards granted prior to September 25, 2005 is based on the grant-date fair-value as determined under the pro forma provisions of SFAS No. 123. The Company recognized incremental stock-based compensation expense of $28 million and $86 million during the third quarter and first nine months of 2006, respectively, as a result of the adoption of SFAS No. 123R.  In accordance with SFAS No. 123R, beginning in the first quarter of 2006 the Company has presented excess tax benefits from the exercise of stock-based compensation awards as a financing activity in the condensed consolidated statement of cash flows.

No stock-based compensation costs have been capitalized as of July 1, 2006.  The income tax benefit related to stock-based compensation expense was $10 million and $36 million for the three and nine months ended July 1, 2006, respectively. As of July 1, 2006, $384.5 million of total unrecognized compensation cost related to stock options and restricted stock units is expected to be recognized over a weighted-average period of 3.08 years.

SFAS No. 123R prohibits recognition of a deferred tax asset for an excess tax benefit that has not been realized. The Company will recognize a benefit from stock-based compensation in equity if an incremental tax benefit is realized by following the ordering provisions of the tax law.  In addition, the Company accounts for the indirect effects of stock-based compensation on the research tax credit, the foreign tax credit, and the domestic manufacturing deduction through the income statement.

Prior to the adoption of SFAS No. 123R, the Company measured compensation expense for its employee stock-based compensation plans using the intrinsic value method prescribed by APB Opinion No. 25. The Company applied the disclosure provisions of SFAS No. 123 as amended by SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, as if the fair-value-based method had been applied in measuring compensation expense. Under APB Opinion No. 25, when the exercise price of the Company’s employee stock options was equal to the market price of the underlying stock on the date of the grant, no compensation expense was recognized.

10




The following table illustrates the effect on net income after taxes and net income per common share as if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based compensation during the three and nine months ended June 25, 2005 (in millions, except per share amounts):

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

6/25/05

 

6/25/05

 

 

 

As Restated (1)

 

As Restated (1)

 

 

 

 

 

 

 

Net income

 

$

319

 

$

900

 

 

 

 

 

 

 

Add: Stock-based employee compensation expense included in reported net income, net of tax

 

11

 

33

 

Deduct: Stock-based employee compensation expense determined under the fair-value-based method for all awards, net of tax

 

(29

)

(87

)

 

 

 

 

 

 

Net income - pro forma

 

$

301

 

$

846

 

 

 

 

 

 

 

Net income per common share

 

 

 

 

 

Basic

 

$

0.39

 

$

1.12

 

Diluted

 

$

0.37

 

$

1.05

 

 

 

 

 

 

 

Net income per common share - pro forma

 

 

 

 

 

Basic

 

$

0.37

 

$

1.05

 

Diluted

 

$

0.35

 

$

0.99

 

 


(1) See Note 2, “Restatement of Condensed Consolidated Financial Statements.”

Further information regarding stock-based compensation can be found in Note 8.

Earnings Per Common Share

Basic earnings per common share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period. Diluted earnings per common share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period increased to include the number of additional shares of common stock that would have been outstanding if the dilutive potential shares of common stock had been issued. The dilutive effect of outstanding options, restricted stock, and restricted stock units is reflected in diluted earnings per share by application of the treasury stock method.  Under the treasury stock method, an increase in the fair market value of the Company’s common stock can result in a greater dilutive effect from outstanding options, restricted stock, and restricted stock units.  Additionally, the exercise of employee stock options and the vesting of restricted stock and restricted stock units can result in a greater dilutive effect on earnings per share.

11




The following table sets forth the computation of basic and diluted earnings per share (in thousands, except net income and per share amounts):

 

Three
Months Ended

 

Nine
Months Ended

 

 

 

7/1/06

 

6/25/05

 

7/1/06

 

6/25/05

 

 

 

 

 

As Restated (1)

 

 

 

As Restated (1)

 

 

 

 

 

 

 

 

 

 

 

Numerator (in millions):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

472

 

$

319

 

$

1,447

 

$

900

 

 

 

 

 

 

 

 

 

 

 

Denominator:

 

 

 

 

 

 

 

 

 

Weighted-average shares outstanding, excluding unvested restricted stock

 

851,375

 

815,092

 

840,759

 

804,098

 

Effect of dilutive options, restricted stock units, and restricted stock

 

24,993

 

45,711

 

36,212

 

49,140

 

 

 

 

 

 

 

 

 

 

 

Denominator for diluted earnings per share

 

876,368

 

860,803

 

876,971

 

853,238

 

 

 

 

 

 

 

 

 

 

 

Basic earnings per share

 

$

0.55

 

$

0.39

 

$

1.72

 

$

1.12

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings per share

 

$

0.54

 

$

0.37

 

$

1.65

 

$

1.05

 

 

Potentially dilutive securities representing approximately 3.0 million and 1.4 million shares (as restated(1)) of common stock for the quarters ended July 1, 2006 and June 25, 2005, respectively, and 3.3 million and 2.5 million shares (as restated(1)) of common stock for the nine months ended July 1, 2006 and June 25, 2005, respectively, were excluded from the computation of diluted earnings per share for these periods because their effect would have been antidilutive. Potentially dilutive securities include stock options, unvested restricted stock and restricted stock units.


(1) See Note 2, “Restatement of Condensed Consolidated Financial Statements.”

Note 2 – Restatement of Condensed Consolidated Financial Statements

In this Form 10-Q, the Company is restating its condensed consolidated balance sheet as of September 24, 2005, the related consolidated statements of operations for the three and nine months ended June 25, 2005, and the related consolidated statement of cash flows for the nine months ended June 25, 2005.  In the Company’s Form 10-K for the year ended September 30, 2006 to be filed with the Securities and Exchange Commission (the “2006 Form 10-K”), the Company is restating its consolidated balance sheet as of September 24, 2005, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the fiscal years ended September 24, 2005 and September 25, 2004, and each of the quarters in fiscal year 2005.

Previously filed annual reports on Form 10-K and quarterly reports on Form 10-Q affected by the restatements have not been amended and should not be relied on.

On June 29, 2006, the Company announced that an internal review had discovered irregularities related to the issuance of certain stock option grants made between 1997 and 2001, including a grant to its Chief Executive Officer (“CEO”) Steve Jobs.  The Company also announced that a Special Committee of outside directors (“Special Committee”) had been formed and had hired independent counsel to conduct a full investigation of the Company’s past stock option granting practices.

As a result of the internal review and the independent investigation, management has concluded, and the Audit and Finance Committee of the Board of Directors agrees, that incorrect measurement dates were used for financial

12




accounting purposes for certain stock option grants made in prior periods.  Therefore, the Company has recorded additional non-cash stock-based compensation expense and related tax effects with regard to past stock option grants, and the Company is restating previously filed financial statements in this Form 10-Q and the 2006 Form 10-K.  These adjustments, after tax, amounted to $4 million, $7 million, and $10 million in fiscal years 2006, 2005 and 2004, respectively.  The adjustment to 2006 was recorded in the fourth quarter of fiscal year 2006 due to its insignificance.

The independent counsel and its forensic accountants (“Investigative Team”) reviewed the facts and circumstances surrounding stock option grants made on 259 dates. Based on a review of the totality of evidence and the applicable law, the Special Committee found no misconduct by current management. The Special Committee’s investigation identified a number of grants for which grant dates were intentionally selected in order to obtain favorable exercise prices.  The terms of these and certain other grants, as discussed below, were finalized after the originally assigned grant dates.  The Special Committee concluded that the procedures for granting, accounting for, and reporting stock option grants did not include sufficient safeguards to prevent manipulation. Although the investigation found that CEO Steve Jobs was aware or recommended the selection of some favorable grant dates, he did not receive or financially benefit from these grants or appreciate the accounting implications. The Special Committee also found that the investigation had raised serious concerns regarding the actions of two former officers in connection with the accounting, recording and reporting of stock option grants.

Based on the evidence and findings from the Company’s internal review and the Special Committee’s independent investigation, an analysis was performed of the measurement dates for the 42,077 stock option grants made on 259 dates between October 1996 and January 2003 (the “relevant period”). The Company believes that the analysis was properly limited to the relevant period. In addition to analyzing all grants made during the relevant period, the Company sampled certain grants between 1994 and 1997 and found none that required accounting adjustments. The first grants for which stock-based compensation expense is required are dated December 29, 1997. The Company also examined grants made after the relevant period and found none that required accounting adjustments.  Moreover, in the years after 2002, Apple made significant changes in its stock option granting practices in response to evolving legal, regulatory and accounting requirements.

Consistent with the accounting literature and recent guidance from the Securities and Exchange Commission (“SEC”), the grants during the relevant period were organized into categories based on grant type and process by which the grant was finalized. The Company analyzed the evidence related to each category of grants including, but not limited to, electronic and physical documents, document metadata, and witness interviews.  Based on the relevant facts and circumstances, the Company applied the controlling accounting standards to determine, for every grant within each category, the proper measurement date.  If the measurement date is not the originally assigned grant date, accounting adjustments were made as required, resulting in stock-based compensation expense and related tax effects.

The 42,077 grants were classified as follows: (1) 17 grants to persons elected or appointed to the Board of Directors (“director grants”); (2) 3,892 grants to employees under the Monday/Tuesday Plan described below (“Monday/Tuesday grants”); (3) 27,096 grants made in broad-based awards to large numbers of employees, usually on an annual basis (“focal grants”); (4) 9,988 other grants ratified at meetings of the Board or Compensation Committee (“meeting grants”); (5) 1,082 other grants ratified by unanimous written consent (“UWC”) of the Board or Compensation Committee (“other UWC grants”); and (6) two grants to the CEO (“CEO grants”).  All references to the number of option shares, option exercise prices and share prices in this Note 2 have not been adjusted for any subsequent stock splits.

With the exception of director grants, all stock option grants were subject to ratification by the Board or Compensation Committee at a meeting or by UWC.  Following approval of the grants at a meeting or by UWC, the Company’s legal staff would prepare a Secretary’s Certificate certifying the ratification of the grants.  Based on the facts and circumstances described below, the Company has concluded that the recipients and terms of certain grants were fixed for accounting purposes before ratification pursuant to parameters previously approved by the Board or Compensation Committee through the Monday/Tuesday Plan and the focal process.  As further discussed below, within these parameters, management had the authority to determine the recipients and terms for each grant.  Thus, the Company has concluded that the measurement dates for these grants occurred when management’s process for

13




allocating these grants was completed and the grants were ready for ratification, which was considered perfunctory.  With regard to all other grants, the Company has concluded that the grants were finalized and the measurement dates occurred when the grants were ratified.  For many grants, however, the dates of ratification cannot be established because the dates the UWCs were executed by the Board or Compensation Committee members or received by the Company are not available.  For such grants, the Company has concluded that the date of the preparation of the Secretary’s Certificate is the best alternative for determining the actual date of ratification.

As discussed below, the Company’s analysis determined that the originally assigned grant dates for 6,428 grants on 42 dates are not the proper measurement dates.  Accordingly, after accounting for forfeitures, the Company has recognized stock-based compensation expense of $105 million on a pre-tax basis over the respective awards’ vesting terms. No adjustments were required for the remaining 35,649 grants.  The adjustments were determined by category as follows:

Director Grants – Seventeen director grants were made during the relevant period.  Two director grants were made pursuant to a 1997 plan that dated the grants on the enactment of the plan.  The remaining fifteen grants were automatically made under the Director Stock Option Plan for non-employee directors, which was approved by shareholders in 1998, on the date of a director’s election or appointment to the Board and on subsequent anniversaries, beginning on the fourth anniversary.  Accordingly, the analysis determined that the originally assigned grant date for each director grant is the measurement date, and no accounting adjustments are required.

Monday/Tuesday Grants – Beginning in December 1998, 3,892 new hire grants and grants for promotion and retention purposes (“promotion/retention grants”) were made during the relevant period under the “Monday/Tuesday Plan.”  Under the Monday/Tuesday Plan, new hire grants made within pre-established guidelines approved by the Board or Compensation Committee were dated on the Monday that the recipient started work (or the following Monday, if the recipient started on another day). The Company’s analysis showed this process to be reliable with very low error rates.  Promotion/retention grants, also based on pre-established guidelines, were made generally on the first Tuesday of each month. The Company has concluded that the new hire and promotion/retention grants made pursuant to the Monday/Tuesday Plan within pre-established guidelines do not require adjustment, with the exception of six grants that were erroneously dated before the employees’ start dates. For 120 new hire and promotion/retention grants made outside the guidelines, however, the Company has concluded that the measurement dates are the dates of ratification by the Board or Compensation Committee rather than the dates used for grants within guidelines.  Accordingly, based on the methodology described above, the Company has recognized stock-based compensation expense of $6 million from 126 grants.

Focal Grants – During the relevant period, 27,096 focal grants were made to employees typically on an annual basis as part of an extensive process that required several months to complete. Pursuant to limits, guidelines and practices previously approved by the Board or Compensation Committee, managers throughout the Company would make recommendations for grants to employees in their areas of responsibility.  After senior management had determined that the grants were made in accordance with these established limits, guidelines and practices, management treated the grants as final when they were submitted to the Board or Compensation Committee for ratification.  The Company has concluded that for 5,595 grants on five dates, the originally assigned grant dates are not the proper measurement dates.  For these grants, management’s process for finalizing the grants was completed after the originally assigned grant dates.  As a result, the Company has recognized $29 million of stock-based compensation expense.  For two of the five grant dates comprising 3,744 grants, the evidence shows that the grants were finalized and the measurement date occurred one day after the originally assigned grant dates.  The grants on these two dates represent more than $16 million of the total $29 million of stock-based compensation expense resulting from focal grants.

Other Meeting Grants – During the relevant period, meetings of the Board or Compensation Committee were held to ratify 9,988 grants that are not Monday/Tuesday, focal or CEO grants. The grant dates and measurement dates for these grants are the meeting dates when the grants were ratified, with the exception of 46 grants.   Forty-two of these 46 grants are dated concurrent with a meeting that considered and approved certain grants, but the evidence indicates that all of the grants may not have been finalized until a later date.  One of the 46 grants was approved and dated at another meeting, but the recipient, who was becoming employed by the Company as part of a corporate acquisition, did not start until a later date. Two other grants were approved before the employees’ start dates.  Another grant was mistakenly cancelled and subsequently reinstated, requiring an accounting adjustment. Thus, for these 46 grants the Company has concluded that the originally assigned grant dates are not the proper measurement dates.  As a result, the Company has recognized $2 million of stock-based compensation expense.

14




Other UWC Grants – During the relevant period, 1,082 grants were approved by UWCs for a variety of purposes, including executive recruitment, retention, promotion and new hires outside the Monday/Tuesday process. These grants were not made pursuant to pre-established guidelines adopted by the Board or Compensation Committee. Therefore, the Company has concluded that these grants were not finalized for accounting purposes until ratification by the Board or Compensation Committee. Accordingly, for 660 grants, the Company has concluded that the originally assigned grant dates are not the proper measurement dates. As a result, the Company has recognized $48 million of stock-based compensation expense.

CEO Grants – During the relevant period, the Company made two grants to CEO Steve Jobs.  The first grant, dated January 12, 2000, was for 10 million option shares.  The second grant, dated October 19, 2001, was for 7.5 million option shares. Both grants were cancelled in March 2003 prior to being exercised, when Mr. Jobs received 5 million shares of restricted stock.

With respect to the grant dated January 12, 2000, the Board on December 2, 1999, authorized a special “CEO Compensation Committee” to grant Mr. Jobs up to 15 million shares.  The evidence indicates that the CEO Compensation Committee finalized the terms of the grant on January 12, 2000, although the Committee’s action was memorialized in a UWC transmitted on January 18, 2000. Because the measurement date is the originally assigned grant date, the Company has not recognized any stock-based compensation expense from this grant. If the Company had determined that the measurement date was the date when the UWC was executed or received, then additional stock-based compensation would have been recognized.

The grant dated October 19, 2001 was originally approved at a Board meeting on August 29, 2001, with an exercise price of $17.83.  The terms of the grant, however, were not finalized until December 18, 2001.  The grant was dated October 19, 2001, with an exercise price of $18.30.  The approval for the grant was improperly recorded as occurring at a special Board meeting on October 19, 2001.  Such a special Board meeting did not occur.  There was no evidence, however, that any current member of management was aware of this irregularity.  The Company has recognized $20 million in stock-based compensation expense for this grant, reflecting the difference between the exercise price of $18.30 and the share price on December 18, 2001 of $21.01.

The incremental impact from recognizing stock-based compensation expense resulting from the investigation of past stock option grants is as follows (dollars in millions):

Fiscal Year

 

Pre-Tax Expense (Income)

 

After Tax Expense

 

 

 

 

 

 

 

1998

 

$

(1

)

$

 

1999

 

8

 

6

 

2000

 

13

 

9

 

2001

 

19

 

13

 

2002

 

29

 

23

 

2003

 

16

 

12

 

2004

 

13

 

10

 

2005

 

7

 

7

 

2006

 

1

 

4

 

Total

 

$

105

 

$

84

 

 

Additionally, the Company has restated the pro forma expense under SFAS No. 123 in Note 1 and in Note 1 of the Notes to Consolidated Financial Statements of the 2006 Form 10-K to reflect the impact of these adjustments.

15




The following table presents the effects of the stock-based compensation and related tax adjustments made to the Company’s previously reported condensed consolidated statements of operations (in millions, except share and per share amounts):

 

 

Three Months Ended June 25, 2005

 

Nine Months Ended June 25, 2005

 

 

 

As
Reported

 


Adjustments

 

As
Restated

 

As
Reported

 


Adjustments

 

As
Restated

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

$

3,520

 

$

 

$

3,520

 

$

10,253

 

$

 

$

10,253

 

Cost of sales (1)

 

2,476

 

 

2,476

 

7,245

 

1

 

7,246

 

Gross margin

 

1,044

 

 

1,044

 

3,008

 

(1

)

3,007

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

Research and development (1)

 

145

 

 

145

 

387

 

1

 

388

 

Selling, general, and administrative (1)

 

472

 

1

 

473

 

1,389

 

4

 

1,393

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

617

 

1

 

618

 

1,776

 

5

 

1,781

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating income

 

427

 

(1

)

426

 

1,232

 

(6

)

1,226

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other income and expense

 

46

 

 

46

 

105

 

 

105

 

Income before provision for income taxes

 

473

 

(1

)

472

 

1,337

 

(6

)

1,331

 

Provision for income taxes

 

153

 

 

153

 

432

 

(1

)

431

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

320

 

$

(1

)

$

319

 

$

905

 

$

(5

)

$

900

 

Earnings per common share:

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

0.39

 

$

(0.00

)

$

0.39

 

$

1.13

 

$

(0.01

)

$

1.12

 

Diluted

 

$

0.37

 

$

(0.00

)

$

0.37

 

$

1.06

 

$

(0.01

)

$

1.05

 

Shares used in computing earnings per share (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

815,092

 

 

815,092

 

804,098

 

 

804,098

 

Diluted

 

860,688

 

115

 

860,803

 

853,105

 

133

 

853,238

 

 


(1) Includes stock-based compensation expense, which was allocated as follows:

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of sales

 

$

 

$

 

$

 

$

1

 

$

1

 

$

2

 

Research and development

 

$

2

 

$

 

$

2

 

$

4

 

$

1

 

$

5

 

Selling, general, and administrative

 

$

9

 

$

1

 

$

10

 

$

26

 

$

4

 

$

30

 

 

16




The following table presents the effects of the stock-based compensation and related tax adjustments made to the Company’s previously reported condensed consolidated balance sheet as of September 24, 2005 (in millions, except share amounts):

 

 

September 24, 2005

 

 

 

As Reported

 

Adjustments

 

As Restated

 

 

 

 

 

 

 

 

 

ASSETS:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

3,491

 

$

 

$

3,491

 

Short-term investments

 

4,770

 

 

4,770

 

Accounts receivable, less allowance of $46

 

895

 

 

895

 

Inventories

 

165

 

 

165

 

Deferred tax assets

 

331

 

 

331

 

Other current assets

 

648

 

 

648

 

Total current assets

 

10,300

 

 

10,300

 

Property, plant, and equipment, net

 

817

 

 

817

 

Goodwill

 

69

 

 

69

 

Acquired intangible assets, net

 

27

 

 

27

 

Other assets

 

338

 

(35

)

303

 

Total assets

 

$

11,551

 

$

(35

)

$

11,516

 

 

 

 

 

 

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

Accounts payable

 

$

1,779

 

 

$

1,779

 

Accrued expenses

 

1,705

 

3

 

1,708

 

Total current liabilities

 

3,484

 

3

 

3,487

 

Non-current liabilities

 

601

 

 

601

 

Total liabilities

 

4,085

 

3

 

4,088

 

 

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

 

 

Common stock, no par value; 1,800,000,000 shares authorized; 835,019,364 shares issued and outstanding

 

3,521

 

43

 

3,564

 

Deferred stock compensation

 

(60

)

(1

)

(61

)

Retained earnings

 

4,005

 

(80

)

3,925

 

Accumulated other comprehensive income

 

 

 

 

Total shareholders’ equity

 

7,466

 

(38

)

7,428

 

Total liabilities and shareholders’ equity

 

$

11,551

 

$

(35

)

$

11,516

 

 

17




Note 3 – Financial Instruments

Cash, Cash Equivalents, and Short-Term Investments

The following table summarizes the fair value of the Company’s cash and available-for-sale securities held in its short-term investment portfolio, recorded as cash and cash equivalents or short-term investments as of July 1, 2006 and September 24, 2005 (in millions):

 

7/1/06

 

9/24/05

 

 

 

 

 

 

 

Cash

 

$

235

 

$

127

 

 

 

 

 

 

 

U.S. Treasury and Agency Securities

 

1,190

 

89

 

U.S. Corporate Securities

 

4,426

 

2,030

 

Foreign Securities

 

2,162

 

1,245

 

Total cash equivalents

 

7,778

 

3,364

 

 

 

 

 

 

 

U.S. Treasury and Agency Securities

 

195

 

216

 

U.S. Corporate Securities

 

855

 

3,662

 

Foreign Securities

 

113

 

892

 

Total short-term investments

 

1,163

 

4,770

 

 

 

 

 

 

 

Total cash, cash equivalents, and short-term investments

 

$

9,176

 

$

8,261

 

 

The Company’s U.S. corporate securities consist primarily of commercial paper, certificates of deposit, time deposits, and corporate debt securities. Foreign securities consist primarily of foreign commercial paper, certificates of deposit, and time deposits with foreign institutions, a majority of which are denominated in U.S. dollars.  The Company had net unrealized losses totaling $4.3 million on its investment portfolio, the majority of which related to investments with stated maturities less than one year as of July 1, 2006, and net unrealized losses of $5.9 million on its investment portfolio, approximately half of which related to investments with stated maturities less than one year as of September 24, 2005.

As of July 1, 2006 and September 24, 2005, approximately $157 million and $287 million, respectively, of the Company’s short-term investments had underlying maturities ranging from 1 to 5 years.  The remaining short-term investments had maturities of 3 to 12 months.

In accordance with FASB Staff Position (“FSP”) FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, the following table shows the gross unrealized losses and fair value for those investments that were in an unrealized loss position as of July 1, 2006 (in millions):

 

Less than 12 Months

 

12 Months or Greater

 

Total

 


Security Description

 


Fair Value

 

Unrealized
Loss

 


Fair Value

 

Unrealized
Loss

 


Fair Value

 

Unrealized
Loss

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. Government Securities

 

$

481

 

$

(1

)

$

52

 

$

 

$

533

 

$

(1

)

U.S. Corporate Securities

 

3,821

 

(2

)

154

 

(2

)

3,975

 

(4

)

Foreign Securities

 

1,339

 

 

29

 

 

1,368

 

 

Total

 

$

5,641

 

$

(3

)

$

235

 

$

(2

)

$

5,876

 

$

(5

)

 

The unrealized losses on the Company’s investments in U.S. Treasury and Agency securities, U.S. corporate securities, and foreign securities were caused primarily by changes in interest rates.  The Company typically invests in highly-rated securities with low probabilities of default.  The Company’s investment policy requires investments to be rated single-A or better. Therefore, the Company considers the declines to be temporary in nature.  As of July 1, 2006, the Company does not consider the investments to be other-than-temporarily impaired.

Market values were determined for each individual security in the investment portfolio. When evaluating the investments for other-than-temporary impairment, the Company reviews factors such as the length of time and extent to which fair value has been below cost basis, the financial condition of the issuer, and the Company’s ability and intent to hold the investment for a period of time, which may be sufficient for anticipated recovery in market value.

18




Derivative Financial Instruments

The Company uses derivatives to partially offset its business exposure to foreign exchange risk. Foreign currency forward and option contracts are used to offset the foreign exchange risk on certain existing assets and liabilities and to hedge the foreign exchange risk on expected future cash flows on certain forecasted revenue and cost of sales. The Company’s accounting policies for these instruments are based on whether the instruments are designated as hedge or non-hedge instruments.  The Company records all derivatives on the balance sheet at fair value. Derivatives that are not hedges are adjusted to fair value through earnings. If the derivative is a hedge, depending on the nature of the hedge, changes in fair value will either be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings, or recognized in other comprehensive income until the hedged item is recognized in earnings. As of July 1, 2006, the Company had a net deferred gain associated with cash flow hedges of approximately $2 million net of taxes, substantially all of which is expected to be reclassified to earnings by the end of the first quarter of fiscal 2007.  As of the end of the third quarter of 2006, the general nature of the Company’s risk management activities and the general nature and mix of the Company’s derivative financial instruments have not changed materially from the end of 2005.

Foreign Exchange Risk Management

The Company may enter into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risk associated with existing assets and liabilities, certain firm commitments, forecasted future cash flows, and net investments in foreign subsidiaries. Generally, the Company’s practice is to hedge a majority of its existing material foreign exchange transaction exposures.  However, the Company may not hedge certain foreign exchange transaction exposures due to immateriality, prohibitive economic cost of hedging particular exposures, or limited availability of appropriate hedging instruments.

Note 4 – Condensed Consolidated Financial Statement Details (in millions)

Other Current Assets

 

7/1/06

 

9/24/05

 

Vendor non-trade receivables

 

$

1,005

 

$

417

 

NAND flash memory prepayments

 

167

 

 

Other current assets

 

350

 

231

 

 

 

 

 

 

 

Total other current assets

 

$

1,522

 

$

648

 

 

Property, Plant, and Equipment, Net

 

7/1/06

 

9/24/05

 

Land and buildings

 

$

611

 

$

361

 

Machinery, equipment, and internal-use software

 

530

 

470

 

Office furniture and equipment

 

91

 

81

 

Leasehold improvements

 

722

 

569

 

 

 

1,954

 

1,481

 

 

 

 

 

 

 

Accumulated depreciation and amortization

 

(757

)

(664

)

Total property, plant, and equipment, net

 

$

1,197

 

$

817

 

 

Other Assets

 

7/1/06

 

9/24/05

 

 

 

 

 

As Restated (1)

 

Long-term NAND flash memory prepayments

 

$

1,083

 

$

 

Non-current deferred tax assets

 

58

 

148

 

Capitalized software development costs, net

 

25

 

38

 

Other assets

 

185

 

117

 

 

 

 

 

 

 

Total other assets

 

$

1,351

 

$

303

 

 

19




Accrued Expenses

 

7/1/06

 

9/24/05

 

 

 

 

 

As Restated (1)

 

 

 

 

 

 

 

Deferred revenue - current

 

$

709

 

$

501

 

Accrued marketing and distribution

 

200

 

221

 

Accrued compensation and employee benefits

 

178

 

167

 

Accrued warranty and related costs

 

287

 

188

 

Deferred margin on component sales

 

269

 

26

 

Other current liabilities

 

867

 

605

 

 

 

 

 

 

 

Total accrued expenses

 

$

2,510

 

$

1,708

 

 

Non-Current Liabilities

 

7/1/06

 

9/24/05

 

Deferred revenue - non-current

 

$

324

 

$

281

 

Deferred tax liabilities

 

423

 

308

 

Other non-current liabilities

 

14

 

12

 

 

 

 

 

 

 

Total non-current liabilities

 

$

761

 

$

601

 

 

Other Income and Expense

 

Three Months Ended

 

Nine Months Ended

 

 

 

7/1/06

 

6/25/05

 

7/1/06

 

6/25/05

 

Interest income

 

$

99

 

$

51

 

$

274

 

$

118

 

Other expense, net

 

(4

)

(5

)

(22

)

(13

)

 

 

 

 

 

 

 

 

 

 

Other income and expense

 

$

95

 

$

46

 

$

252

 

$

105

 

 


(1) See Note 2, “Restatement of Condensed Consolidated Financial Statements.”

Note 5 – Goodwill

During the third quarter of 2006, the Company sold certain assets related to its PowerSchool web-based student information system operations.  In connection with this sale, the Company reduced goodwill by $31 million for the outstanding balance from the acquisition of PowerSchool, Inc. in 2001 and recognized a $4 million pre-tax gain, which is reflected in other income and expense in the condensed consolidated statement of operations.

Note 6 – Income Taxes

On October 22, 2004, the American Jobs Creation Act of 2004 (“AJCA”) was signed into law.  The AJCA includes a provision for the deduction of 85% of certain foreign earnings that are repatriated, as defined in the AJCA, within a specified time frame. Among other requirements, dividends qualifying for the 85% deduction must be reinvested in the United States in certain qualified investments pursuant to a domestic reinvestment plan approved by the Chief Executive Officer (“CEO”) and Board of Directors.  During the third quarter of 2006, the Company initiated a plan to repatriate approximately $1.5 billion of foreign earnings prior to the end of fiscal 2006, of which approximately $1.3 billion was repatriated during the third quarter, and of which $755 million is eligible for the reduced tax rate provided by the AJCA.  Accordingly, the Company recorded a tax charge of $54 million related to the repatriation of foreign earnings under the provisions of the AJCA. In addition, the Company recorded a tax benefit of $78 million resulting from the implementation of tax planning strategies to realize deferred tax assets that were previously not recognizable within certain foreign subsidiaries.

Note 7 – Shareholders’ Equity

Preferred Stock

The Company has five million shares of authorized preferred stock, none of which is outstanding. Under the terms of the Company’s Restated Articles of Incorporation, the Board of Directors is authorized to determine or alter the rights, preferences, privileges, and restrictions of the Company’s authorized but unissued shares of preferred stock.

20




Restricted Stock Units

The Company’s Board of Directors has granted restricted stock units to members of the Company’s senior management team, excluding its CEO. These restricted stock units generally vest over four years either at the end of the four-year service period, in two equal installments on the second and fourth anniversaries of the date of grant, or in equal installments on each of the first through fourth anniversaries of the grant date.  Upon vesting, the restricted stock units will convert into an equivalent number of shares of common stock. The amounts of the restricted stock units expensed by the Company are based on the closing market price of the Company’s common stock on the date of grant and are amortized on a straight-line basis over the four-year requisite service period. The restricted stock units have been reflected in the calculation of diluted earnings per share utilizing the treasury stock method.

Previously granted restricted stock units that vested during the third quarter and first nine months of 2006 were 25,000 and 2.43 million, respectively.  A majority of these vested restricted stock units were net-share settled such that the Company withheld shares with value equivalent to the employees’ minimum statutory obligation for the applicable income and other employment taxes, and remitted the cash to the appropriate taxing authorities.  The total shares withheld of 11,438 and 965,517 for the three and nine months ended July 1, 2006, respectively, were based on the value of the restricted stock units on their vesting date as determined by the Company’s closing stock price.  Total payments for the employees’ tax obligations to the taxing authorities were approximately $58 million.  These net-share settlements had the effect of share repurchases by the Company as they reduced and retired the number of shares that would have otherwise been issued as a result of the vesting and did not represent an expense to the Company.

CEO Restricted Stock Award

On March 19, 2003, the Company’s Board of Directors granted 10 million shares of restricted stock to the Company’s CEO that vested on March 19, 2006. The amount of the restricted stock award expensed by the Company was based on the closing market price of the Company’s common stock on the date of grant and was amortized on a straight-line basis over the three-year requisite service period.

Upon vesting during the second quarter of 2006, the restricted stock award was net-share settled such that the Company withheld shares with value equivalent to the CEO’s minimum statutory obligation for the applicable income and other employment taxes, and remitted the cash to the appropriate taxing authorities.  The total shares withheld of 4.6 million was based on the value of the restricted stock award on the vesting date as determined by the Company’s closing stock price of $64.66.  The remaining shares net of those withheld were delivered to the Company’s CEO. Total payments for the CEO’s tax obligations to the taxing authorities were approximately $296 million.  The net-share settlement had the effect of share repurchases by the Company as it reduced and retired the number of shares outstanding and did not represent an expense to the Company.

Stock Repurchase Plan

In July 1999, the Company’s Board of Directors authorized a plan for the Company to repurchase up to $500 million of its common stock.  This repurchase plan does not obligate the Company to acquire any specific number of shares or acquire shares over any specified period of time.  The Company has repurchased a total of 13.1 million shares at a cost of $217 million under this plan and was authorized to repurchase up to an additional $283 million of its common stock as of July 1, 2006.

Comprehensive Income

Comprehensive income consists of two components, net income and other comprehensive income. Other comprehensive income refers to revenue, expenses, gains, and losses that under U.S. generally accepted accounting principles are recorded as an element of shareholders’ equity but are excluded from net income. The Company’s other comprehensive income consists of foreign currency translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency, unrealized gains and losses on marketable securities categorized as available-for-sale, and net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges.

21




The following table summarizes components of total comprehensive income, net of taxes, during the three and nine months ended July 1, 2006 and June 25, 2005 (in millions):

 

Three
Months Ended

 

Nine
Months Ended

 

 

 

7/1/06

 

6/25/05

 

7/1/06

 

6/25/05

 

 

 

 

 

As Restated
(1)

 

 

 

As Restated
(1)

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

472

 

$

319

 

$

1,447

 

$

900

 

Other comprehensive income:

 

 

 

 

 

 

 

 

 

Net change in unrealized derivative gains/losses

 

1

 

11

 

(2

)

19

 

Change in foreign currency translation

 

19

 

(12

)

16

 

3

 

Net change in unrealized investment gains/losses

 

1

 

6

 

2

 

2

 

Reclassification adjustment for investment gains included in net income

 

 

(2

)

 

 

 

 

 

 

 

 

 

 

 

 

Total comprehensive income

 

$

493

 

$

322

 

$

1,463

 

$

924

 


(1) See Note 2, “Restatement of Condensed Consolidated Financial Statements,” in Notes to Condensed Consolidated Financial Statements.

The following table summarizes the components of accumulated other comprehensive income (loss), net of taxes (in millions):

 

7/1/06

 

9/24/05

 

 

 

 

 

 

 

Unrealized gains on derivative investments

 

$

2

 

$

4

 

Cumulative foreign currency translation

 

16

 

 

Unrealized losses on available-for-sale securities

 

(2

)

(4

)

Accumulated other comprehensive income

 

$

16

 

$

 

 

The following table summarizes activity in other comprehensive income related to derivatives, net of taxes, held by the Company during the three and nine months ended July 1, 2006 and June 25, 2005 (in millions):

 

Three
Months Ended

 

Nine
Months Ended

 

 

 

7/1/06

 

6/25/05

 

7/1/06

 

6/25/05

 

 

 

 

 

 

 

 

 

 

 

Change in fair value of derivatives

 

$

2

 

$

12

 

$

9

 

$

4

 

Adjustment for net gains (losses) realized and included in net income

 

(1

)

(1

)

(11

)

15

 

Change in unrealized derivative gains (losses)

 

$

1

 

$

11

 

$

(2

)

$

19

 

 

Employee Benefit Plans

2003 Employee Stock Plan

The 2003 Employee Stock Plan (the “2003 Plan”) is a shareholder approved plan that provides for broad-based grants to employees, including executive officers. Based on the terms of individual option grants, options granted under the 2003 Plan generally expire 7 to 10 years after the grant date and generally become exercisable over a period of four years, based on continued employment, with either annual or quarterly vesting. The 2003 Plan permits the granting of incentive stock options, nonstatutory stock options, restricted stock units, stock appreciation rights, and stock purchase rights.

1997 Employee Stock Option Plan

In August 1997, the Company’s Board of Directors approved the 1997 Employee Stock Option Plan (the “1997 Plan”), a non-shareholder approved plan for grants of stock options to employees who are not officers of the Company. Based on the terms of individual option grants, options granted under the 1997 Plan generally expire 7 to

22




10 years after the grant date and generally become exercisable over a period of four years, based on continued employment, with either annual or quarterly vesting. In October 2003, the Company terminated the 1997 Plan and no new options can be granted from this plan.

1997 Director Stock Option Plan

In August 1997, the Company’s Board of Directors adopted a Director Stock Option Plan (“Director Plan”) for non-employee directors of the Company, which was approved by shareholders in 1998. Pursuant to the Director Plan, the Company’s non-employee directors are granted an option to acquire 30,000 shares of Common Stock upon their initial election to the Board (“Initial Options). The Initial Options vest and become exercisable in three equal annual installments on each of the first through third anniversaries of the grant date. On the fourth anniversary of a non-employee director’s initial election to the Board and on each subsequent anniversary thereafter, the director will be entitled to receive an option to acquire 10,000 shares of Common Stock (“Annual Options”). Annual Options are fully vested and immediately exercisable on their date of grant.

Rule 10b5-1 Trading Plans

Certain of the Company’s executive officers, including Mr. Timothy D. Cook, Ms. Nancy R. Heinen (formerly an executive officer), Mr. Peter Oppenheimer, Mr. Jonathan Rubinstein (formerly an executive officer), Mr. Philip W. Schiller, and Dr. Bertrand Serlet, have entered into trading plans pursuant to Rule 10b5-1(c)(1) under the Securities Exchange Act of 1934, as amended. A trading plan is a written document that pre-establishes the amounts, prices, and dates (or formula for determining the amounts, prices, and dates) of future purchases or sales of the Company’s stock, including the exercise and sale of employee stock options, shares acquired pursuant to the Company’s employee stock purchase plan, and the sale of shares upon vesting of restricted stock units.

Employee Stock Purchase Plan

The Company has a shareholder approved employee stock purchase plan (the “Purchase Plan”), under which substantially all employees may purchase common stock through payroll deductions at a price equal to 85% of the lower of the fair market values as of the beginning and end of six-month offering periods. Stock purchases under the Purchase Plan are limited to 10% of an employee’s compensation, up to a maximum of $25,000 in any calendar year. The number of shares authorized for issuance is limited to a total of one million shares per offering period.  As of July 1, 2006, approximately 2.3 million shares were reserved for future issuance under the Purchase Plan.

Stock Award Activity

A summary of the Company’s stock award activity and related information for the nine months ended July 1, 2006 is set forth in the following table (stock award amounts and aggregate intrinsic value are presented in thousands):

 

 

 

 

 

 

Outstanding Options

 

 

 

 

 

Shares
Available

 

Number of

 

Weighted-
Average

 

Weighted-
Average Remaining

 

Aggregate

 

 

 

For Grant

 

Shares

 

Exercise Price

 

Contractual Term

 

Intrinsic Value

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance at 9/24/05

 

58,957

 

73,221

 

$

17.79

 

 

 

 

 

Options Granted

 

(3,045

)

3,045

 

$

66.12

 

 

 

 

 

RSUs Granted

 

(2,700

)

 

 

 

 

 

 

Options Cancelled

 

2,000

 

(2,000

)

$

28.26

 

 

 

 

 

RSUs Cancelled

 

625

 

 

 

 

 

 

 

Options Exercised

 

 

(19,545

)

$

11.53

 

 

 

 

 

Plan Shares Expired

 

(73

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance at 7/1/06

 

55,764

 

54,721