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In a blow to its reputation as a finance paragon, GE settles SEC fraud claims related to hedge accounting and revenue recognition.
Marie Leone and Tim Reason, CFO.com | US
August 4, 2009
Some members of the General Electric accounting staff worked hard to figure out ways to hide the negative accounting impacts of transactions booked in 2002 and 2003, according to court documents released by the Securities and Exchange Commission.
In fact, the SEC complaint relates several instances of round-robin email discussions among GE accountants, internal auditors, executives, and the company's external auditor, KPMG, debating whether aggressive accounting would past muster with regulators.
Ultimately, it didn't.
Today, after a four-year investigation, GE settled accounting fraud charges with the SEC for allegedly misleading investors with improper hedge accounting and revenue recognition schemes. Specifically, GE was charged with violating accounting rules when it changed its original hedge documentation to avoid recording fluctuations in the fair value of interest rates swaps, which would have dragged down the company's reported earnings-per-share estimates.
In addition, the SEC charged GE with concocting schemes to accelerate the recognition of revenue from its locomotive and aircraft spare parts business, to make the company's financial results appear healthier than they actually were.
Without admitting or denying guilt, GE paid a fine of $50 million, and agreed to remedial action related to internal control enhancements. "GE bent the accounting rules beyond the breaking point," noted Robert Khuzami, director of the SEC's Division of Enforcement, in a statement.
David P. Bergers, director of the SEC's Boston Regional Office, which led the investigation, would not specify the number of SEC accountants and attorneys involved in the investigation, but told CFO that the agency "deployed a significant number of resources" to bring what he called "a significant case for the SEC and the Boston office" to a successful conclusion. "We will not let the size or complexity of the organization or its accounting deter us from uncovering fraud and other misconduct," he said. "Investors have a right to rely on a company's financial statements."
The SEC uncovered the violations after conducting "risk-based" investigations at GE, in which the government staffers identify a potential risk in an industry or at a particular company and develop a plan to test whether the problem actually exists. In the case of GE, the SEC identified potential misuse of hedge accounting as a possible risk area.
The SEC filed its complaint in the U.S. District Court for the District of Connecticut pointing out that GE met or exceeded analysts' consensus earnings-per-share expectations every quarter from 1995 through filing of its 2004 annual report. However, the SEC charged that during 2002 and 2003, "high-level GE accounting executives or other finance personnel approved accounting that did not comply with generally accepted accounting principles" in order to hit the EPS estimates.
GE, which is often cited for operating a corporate finance department that is second-to-none with respect to efficiency, discipline and innovation, has already adjusted its books and cleaned up its accounting as of February 2008. "We have concluded that it is in the best interests of GE and its shareholders to resolve this matter," said company officials in a written statement. "The errors at issue fell short of our standards, and we have implemented numerous remedial actions and internal control enhancements to prevent such errors from recurring."
According to GE, the company produced 2.9 million documents, and spent $200 million over four years in legal and accounting fees, to cooperate with the SEC's probe and conduct its own "comprehensive review" of the problems. In the second quarter of 2007, the company noted in a regulatory filing that it took disciplinary action against employees involved in the locomotive transactions, which included firing workers who "engaged in intentional misconduct."
Despite its sterling reputation for financial management, GE also has long been the subject of charges from critics that its reliable earnings derived not from the natural smoothing effect of its diversified holdings, but its ability to use that complex structure — including financing arm GE Capital Corp — to manage earnings. "We have not used the words 'earnings management,' but we have said GE misapplied accounting rules so it could cast its financial results in a better light," Bergers told CFO.
The complaint filed by the SEC provides details of the accounting treatments GE tried to pass off as GAAP compliant. For instance, during the periods under investigation, GE issued commercial paper to fund assets that had long, fixed-term interest rates. Because the rolling commercial paper program exposed GE to fluctuations in variable, short-term interest rates, the company sought to hedge its exposure with interest rate swaps. GE was intent on qualifying for hedge accounting, which is considered advantageous because gains and losses on derivatives — in this case the swaps — can be deferred until they mature.
But in early 2003, GE changed its hedge accounting to accomplish two goals: to avoid reporting a disclosure that might have led to the loss of hedge accounting for its entire commercial paper program, and avoid recording what GE estimated to be an approximately $200 million pre-tax charge to earnings, noted the SEC. For months before, GE had struggled to solve its commercial paper hedge accounting issues with proposals based on its established accounting approach. But none of the ideas permitted GE to avoid "certain potentially harmful disclosures," concluded the regulator.
According to court documents, days before GE's quarterly results were to be released in 2003, the company developed an entirely new approach that, "when applied retroactively to transactions that occurred months before, allowed GE to obtain the desired accounting results." The new approach violated GAAP, asserted the SEC. As a result, GE overstated earnings in the fourth quarter of 2002 by more than 5%, and thereby met its revised consensus EPS estimates, added the SEC in its complaint.
The fact that GE had not missed consensus estimates for the previous eight years "is signficant," Berger told CFO. "The motivation [for the accounting change] was to increase earnings."
In addition to reworking its accounting approach, the SEC charged that GE also improperly used the so-called shortcut accounting treatment for its swaps, which it was ineligible to use.
The revenue recognition schemes were a bit different, in that they enlisted the use of a middleman to allow GE to record revenue before products were sold to the end user, according to the complaint. In the fourth quarters of 2002 and 2003, GE "improperly" booked revenue of $223 million and $158 million, respectively, for six locomotives reportedly sold to financial institutions, "with the understanding that the financial institutions would resell the locomotives to GE's railroad customers in the first quarters of the subsequent fiscal years."
The idea was that GE could book the sales made to the financial institution in the current year, while they allowed their railroad customers to purchase the locomotives at their convenience some time in the future. The problem, noted the SEC, was that the six transactions were not true sales, and therefore did not qualify for revenue recognition under GAAP. Indeed, GE did not cede ownership of the trains to the financial institution. Under GAAP, revenue generally cannot be recognized on a product sale unless delivery has occurred, which means the customer has taken title and assumed the risks and rewards of ownership. In fact, the agreement with the financial institution required that GE run the locomotives in idle to prevent damage from the cold, fuel and monitor the idling locomotives, and provide security to the trains, claimed the SEC.
Asked how the SEC's investigation into GE's hedging practices resulted in a revenue recognition charge for the locomotives, Bergers said "It's not unusual for an investigation that begins looking at one thing to expand into other areas if it seems appropriate."
GE also made a critical accounting error with regard to its aircraft engine spare parts business. In March 2002, the SEC alleges that GE changed how it accounted for its sale of the spare parts in two ways. First, the company removed spare parts transactions from a model used to account for sales of aircraft engines, and that adjustment resulted in an immediate $844 million charge to revenue. Then, to offset the charge and avoid disclosing the original accounting method, "GE simultaneously made a second, related change to another accounting model," which did not comply with GAAP. In the end, "GE's error improperly overstated GE's 2002 net earnings by approximately $585 million," concluded the SEC.