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Business risk and risk assessment: Apple Essay

I. The Company’s Core Business Processes and Strategic Objectives

The Company’s products can be divided into two main categories, personal computers and related products and portable digital music players and related products. Based on the annual report, the “Company designs, manufactures and markets” (Annual Report 2005 1) many variations of the products mentioned above. The more popular products of the Company include the “Macintosh line of desktop and notebook computers, the iPod digital music player, the Xserve G5 server and Xserve RAID storage products, a portfolio of consumer and professional software applications, the Mac OS X operating system, the iTunes Music Store, a portfolio of peripherals that support and enhance the Macintosh and iPod product lines, and a variety of other service and support offerings” (1).

Design is mainly a concern of the Company’s research and development. Because the Company is in the technology industry, research and development is a crucial component of its operations. It is the manner by which the Company keeps its competitive advantage. In its annual report, the Company admitted that “the Company’s ability to compete successfully is heavily dependent upon its ability to ensure a continuing and timely flow of competitive products and technology to the marketplace” (14).

As a corollary issue to research and development, creation, protection and acquisition of intellectual property rights are also a major concern for the Company. The Company is in possession of several patents and copyrights. On one hand, the Company is concerned with the protection of its patent, copyrights, trademarks and service marks worldwide. In the other, it must protect itself from infringing on others intellectual property rights. The Company does not only rely on its ability to create intellectual property, it also relies on those owned by third parties which are acquired through licensing agreements.

Because the Company is engaged in producing technology year after year, the manufacture of the Company’s products may create complications. The Company manufactures personal computers and accessories, iPod digital music players and accessories and a variety of consumer and business software applications. The raw materials for these products are sourced elsewhere. There are certain key components that are sourced from one or limited outside source (Annual Report 2005 14). In 2005 and 2004, the Company experienced delays in relation to one of its products, the PowerPC G5 processors (14). This led to the non-availability of certain Apple products from the market (14). After this incident, the Company announced its intention to shift its Macintosh personal computers from PowerPC G5 and G4 processors to Intel Microprocessors (Apple to use Intel para. 1). This transition is expected to be fully implemented in 2007.

The Company’s development of new products requires custom made raw materials that are initially single-sourced until the Company determines the need to develop new sources (Annual Report 2005 14). The manufacture of raw materials and the assembly of some of the Company’s products are made in several foreign countries by third party vendors.

The Company’s marketing is done through the Company’s website, company-owned retail stores, direct selling by the Company’s sale force and third party wholesalers, resellers, and value added resellers. The Company’s main markets are usually in the following fields: education, business, creative and consumer market (Annual Report 2005 12). In 2005, the US education industry accounted for more than 12% of the Company’s net sales (12). The Company is not dependent on any single customer for its income. In fact, no single customer of the Company accounted for more than 10% of its sales for three succeeding fiscal years, 2003 to 2005 (12).

The Company is divided into four reportable operating segments, America, Europe, Japan, and Retail. It also has an operating segment in Asia-Pacific. The three geographical segments mentioned above do not include retail. The Retail segment operates in the United States, Canada, United Kingdom, and Japan. (3)

The Company intends to continue its substantial investment in research and development. The Company’s strategic plan includes the improvement of the Company’s existing products, as well as the development of new ones (7). The Company also believes in the capitalizing in the convergence of digital consumer products (7). This is in keeping with industry trend. For example, both the Company and Microsoft have patents that would improve or create wifi-sharing ability (wireless connectivity) in iPod, iPhone and Zune (Cheng para. 1). Zune, Micosoft’s digital music player, already has a wireless sharing capability which the iPod hopes to emulate. The new patent of the Company may also make it possible for the consumer to directly purchase media from a server through the iPod or iPhone (para 5 and 6).

The Company also plans to continue to exploit the perceived advantages of the Company’s products. These advantages are “innovative industrial design, intuitive ease-of-use, and built-in networking, graphics and multimedia capabilities” (Annual Report 2005 2).

Another shift in the Company’s product development is the shift to “a greener apple.” The Company announced its intention to continue to remove toxic waste from new products and aggressively recycle old products (Jobs). The Company claims that it is leading the industry’s efforts to create more environmentally responsible company and products. The Company plans to create more energy efficient products in the future (para. 29). The Company is not alone in this. Other companies also exerted efforts to show social and environmental awareness. Sometime in 2007, Google released a more energy saving “black screen” after a study showing that a blacks screen uses less electricity than a white one.

As far as its marketing is concerned, the Company plans to expand the distribution of its products. In the past year it has focused on adding on to its direct selling capabilities and the improvement of its sales staff. The Company will continue this style by building more Company-owned store in high traffic locations (Annual Report 2005 8). It also aims to widen its consumer base by targeting first-time computer owners and those people who do not own a Macintosh computer (8). The Company also plans to continue building brand awareness by increasing investment in marketing and advertising as shown by the increase in selling expenses over the years.

II. Business Risks

Research and development is a major component of the Company’s business risk. It involve a significant amount of the Company’s resources, with research and development expenditures amounting to $534 million, $489 million, and $471 million in 2005, 2004, and 2003, respectively (Annual report 2005 13). The benefits are also contingent on several factors, including the ability of the Company to determine which products or innovations can be successfully developed, manufactured and marketed. There is always the risk of choosing the wrong innovation to focus resources on. The failure to produce marketable products regularly means loss of resources and market standing.

Research and development also has a legal risks involved. The Company has admitted that because of the rapid change in technology and the pace by which new patents are being issued, “it is possible certain components of the Company’s products and business methods may unknowingly infringe existing patents of others” (15).

Aside from suits relating to infringement of intellectual property rights, the Company is also facing various suits in relation to its products and a derivative suit filed by its shareholders involving unfair competition and false and misleading proxy statements. In 2006, the Company was placed under scrutiny due to stock option grants, some of which are issued to the Company’s CEO, Steve Jobs, in 1997 and 2001 (Iwata). There were allegations of stockholders that the grant was part of a “backdating scheme”, a scheme were it is made to appear that the options are transacted at a later date when the shares are valued lower (Apple comes under scrutiny).

The investigation showed thousands of backdating grants including two made to CEO Jobs, the second of which did not observe the requirements for validity (Iwata). CEO Jobs was not held accountable for the irregularity of the grant. However, because of the irregularity in the stock options grants issued, the Company restated prior years’ financial statements. Because of these events, the Company admitted in its annual report (2006) the there is further risk of “litigation, regulatory proceedings and government enforcement actions” (21).

The manufacturing of the Company’s products raises some special concerns. As stated above certain key components can only be obtained from a single or limited source (Annual Report 2005 13). Even key components that are not from a single or limited source are sometimes subject to “availability constraints and pricing pressures” (13). In facts, sometime in 2005 and 2004, the company already experienced delays in acquiring key components which led the Company to change one of the major components of one of its products. The Company admits that the loss of certain suppliers would have an adverse effect on the Company (14).

Because of this, there is a risk that the Company will not be able to meet demands for the Company’s products or that the Company will incur delay in the delivery the products ordered by customers. The Company also relies on third parties to supply digital content in its iTunes stores and to develop certain software applications. The failure of third parties to supply digital content does not only affect the performance of iTune stores but also the dominant position of the Company’s digital music player. In the same manner, the failure of software developers to develop programs compatible with the Company’s computer platform due to bigger market for Windows and Linux will adversely affect the demand for the Company’s personal computers.

The use of foreign third party vendors in the final assembly of the Company’s portable products and as suppliers of raw materials increases the Company’s risk of being adversely affected by political and economic conditions in these foreign countries. Political upheaval and economic crisis in foreign countries can affect suppliers’ ability to meet the Company’s demand.

The Company faces cut throat competition on many of its products. In the advent of personal computers, the Company owns a significant chunk of the market. Over the years, the Company’s market share grew smaller and smaller. In July 2006, the Company’s market share is around 2.2% (Apple market share myth), a significant drop from its original market share. However, percentage figures do not account for the growth in the PC market since its birth in the 1980’s. The decline in the Company’s market share can also be attributed to the growth of numerous generic brands that are much cheaper than the Company’s Mac computers. The proliferation of “clones” led many companies to lower their prices and profit margin to gain a bigger market share.

There is an on going price competition in the PC market, and the Company is striving to be competitive in this area. However, the Company’s business strategy seems to focus less in making cheaper PCs but more on developing products that appeal to its niche market, such as the creative market (Annual Report 2005 2). This strategy of the Company is a business risk because the limited market base makes it more vulnerable to economic factors. Decline in spending ability of one of its niche market can have a greater impact on the company than if it has diverse market. On the other hand, it removes the Company from the competition in market segments that are already saturated with other players.

Some analysts believe that part of the upside of the Company’s strategy is that it has refused to compete in a market over which Microsoft already has a monopoly (Apple market share myth). Microsoft has acquired a monopoly in the industry by selling cheap PCs with expensive software or a system called “exclusive software bundling.” This makes it difficult for other companies to develop operating system’s that are competitive with Microsoft’s. The Company’s strategy in focusing on the improvement of what the consumers perceived as the functional and design advantages of the Macintosh platform opens the Company to the risk mentioned above but it also removes it from the competing in saturated markets.

The digital music player market is expected to grow up to 286 million units in 2010 (Guza para.1). The Company’s own product, iPod, continues to dominate the market; however, many competitors are cropping up, challenging the Company’s dominant position. Analyst believes that the Company should not be complacent regarding its dominant position in the business since the digital music player market is young and has only penetrated a small portion of the market in the United States (Siklos). Although many competitors have tried to challenge the Companies and failed, the competition is not giving up. Competitor, Microsoft, came up with Zune, its own brand of digital music player that is compatible with Microsoft’s own on-line music store. Samsung, Sandisk and Creative have came out with products of their own. Software, hardware and on-line companies are working together to address technical difficulties in the initial launch of their own digital music players, and improving their services (Wingfield para. 4). There is a risk that the Company’s music related products may follow the road of its personal computers.

III. Three Most Significant Financial Statement Accounts

The three most significant financial statement accounts for the Company are research and development, inventory, and common stock.

Research and development is significant because the Company is engaged in the production and marketing of technology. Not only is research and development expense significantly higher compared to other industry, it is also the cost which enables the Company to continue its existence. In the industry where the Company belongs, obsolescence happens very fast. If the Company fails to innovate, there will come a time that the Company itself will be obsolete since the consumers have switched to the more recently developed products. Many of the Company’s strategic plans are tied up with research and development, such as the plans to improve existing products and the move towards convergence of digital products.

The plans of the company to improve and to add innovations to existing products will involve a significant amount of the Company’s resources. The amount of the company’s resources spent in research and development are expensed outright, except for the costs which are incurred after the innovation has been determined to be technologically feasible (Annual Report 2005 68).

The failure of the Company to produce technologically feasible products may increase research and development expense, in the same manner that the success of developing technologically feasible products does not necessarily decrease research and development expense. If all the cost for development of the product was incurred before it was determined to be technologically feasible, all cost are expensed outright regardless of feasibility. Based on the Company’s financial statements, capitalization of research and development expense is minimal (77).

Inventory is significant for the Company since its operations involved both manufacturing and retail. The Company’s inventory is subject to several business risks already discussed above. In relation to the supplies issue, the Company entered into long-term supply agreements with several companies which bound the Company to these suppliers until 2010. As part of the agreement, the Company is required to make prepayment amounting to $1.25 billion in the second quarter of 2006. (Annual Report 2005 91)

Part of the Company’s objectives is to ensure a continuing and timely flow of competitive products and technology to the marketplace. The achievement of this objectives means that the Company’s inventory levels are always sufficient to meet demands for the Company’s products. This would also mean that the Company has successfully managed it inventory during the year. Proper management of inventory would result in a year end inventory level is not too high or to low.

The Company’s common stock is significant for the year 2006 because of the discovered irregularities in the issuance of stock option grants issued in 1997 and 2001. These resulted in allegations of fraud and falsification of documents (Wearden para.4). The Company has already investigated the matter, and the result of such investigation has exonerated CEO Steve Jobs of any misconduct. However, restatements of prior years’ financial statements were made, including the common stock and other related accounts (para. 3). This account is not necessarily affected by the Company’s strategic objectives. The stock option grant issue itself affected the performance of the Company’s stock in the market and even raised the issue of possibly delisting from NASDAQ, but which turned out be without bases.

IV. Management Assertions

The management assertions relevant to research and development expense are completeness, accuracy, cut-off and classification. Completeness is a relevant management assertion because research and development is an expense account, and so, there is a risk that the Company will not include all research and development cost incurred in order to increase the net income for the year. Accuracy is relevant because there is a risk that transactions relating to this account are not recorded properly, resulting in under or over statement of the expense account and, in effect, of net income for the fiscal year.

Cut-off is relevant for research and development so that there is proper matching of the expense with the revenue earned during the fiscal year. Failure to record expense in the correct accounting period can also result to over or under statement of the net income for the year. Classification is also a relevant for research and development because there is a risk that the Company will capitalize research and development improperly resulting in the over statement of net income for the year and inflating the Company’s asset even if there are no expected future benefits. Failure to record the amount in the proper account can also mean that there is no matching of income and expense.

The management assertions relevant to inventory are existence, valuation and rights. Existence is a relevant management assertion because there is a risk that the Company will record assets that are not there in order to make the financial conditions of the Company look better to investors. The recording of assets that do not exist can also mean failure to record expenses which, in effect, results to overstatement of net income. Valuation is also a relevant because there is a risk that the Company may overstate the value of the asset to improve the financial statement of the Company. In either management assertions, there is a risk of management inflating the asset of the Company usually to improve the stockholders’ equity of the Company. Management assertions as to rights over inventory is also relevant because there is a risk that the Company included in its assets, inventories whose ownership has already passed to another, to improve the financial statements of the Company.

The management assertions relevant to common stock are existence and valuation. Existence is a relevant management assertion because there is a risk that the Company records stocks which are not actually subscribed and issued or issues stock for which no consideration was actually received by the Company, also called watered stocks. Valuation is also relevant because there is a risk that the Company will over value the property received in consideration for the stocks issued, particularly if the stock is issued for consideration other than cash, making it appear that the Company is better off than it actually is. Both management assertions can be used by the Company to lure investors to invest in the Company under false pretenses.

Although wrong management assertions can be a result of other causes that are not deliberate on the part of management, such as mistakes. The assertions mentioned above are relevant to those accounts because there is the additional risk of deliberate misstatement on the part of management.

V. Environmental Risks

There is a low inherent, control and detection risk in management assertions of completeness and accuracy of the research and development expense based on the Company’s conservative approach in recording research and development, as well as, the relative simplicity of identifying and recording research and development expense.

On the other hand, the management assertion relating to the cut-off of research and development expense is assessed as having high inherent, control and detection risk because of the lack of sufficient data regarding the Companies processes and controls relating to this account. Because the risks mentioned above are assessed at maximum, more substantial test shall be performed to decrease audit risk.

There is a high inherent risk in the classification of research and development expense because of the difficulty of determining technological feasibility. The determination of Technological feasibility can be extremely subjective. On the other hand, there is low control and detection risk in the classification of research and development expense because based on the Company’s past practices, the Company is very conservative in capitalizing research and development expenses. The percentage of research and development expense capitalized by the Company is very small compared to the research and development expense incurred every year. It is the Company’s policy to record all development cost incurred before determination of technological feasibility as expense, and the determination of technological feasibility is usually done after a large portion of the cost of development has been incurred so that only a small portion of the cost is actually capitalized and amortized.

The inherent, control and detection risk is high for all assertions related to inventory because the operations of the Company is complex and international. The final assemblies of some of the Company’s products which are performed by the Company itself are in different locations outside the United States. There are also final assemblies of the Company products that are performed by third parties in different countries in Asia. The Company also takes advantage of several ways of marketing its products. It uses company-owned stores, direct selling, third party sellers and on-line selling. These make it extremely difficult to keep track of the movement of the inventory and to determine when ownership over the inventory change hands.

The inherent risk is assessed as high for the management assertion of existence and valuation of common stock. This is because of the investigation which the Company itself initiated in relation to its stock options grant. The investigation caused the Company to adjust its income from prior years amounting to $84 million. The Company also has stock-based compensation plans consisting of stock options grants and stock purchase plans (Annual Report 2005 88) which calls for complicated computations. The control and detection risk is assessed as low for the management assertion of existence and valuation of common stock because of the Company’s efforts to investigate the matter as soon as the problem arose. It was the Company itself that announced the existence of irregularities in the issuance of its stock options grant. The Company has put in placed control mechanisms to address the matter. Moreover, records of the investigation conducted can help the auditor minimize detection risk.

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