Apple Investor Relations SEC Filings

10-Q

APPLE INC filed this Form 10-Q on Dec 29, 2006

Entire Document

<< Previous Page | Next Page >>

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

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.

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.

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

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.

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.

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.

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.

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

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.

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.

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.

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.

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.

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.

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.

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.

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		—