Case 7-3 GE: "Imagination at Work"

Back on January 16, 2003, after more than 23 years, General Electric (GE) Co. decided to dump its well-recognized slogan, We Bring Good Things to Life, and decided to spend more than $100 million to launch a new campaign with the tagline, Imagination at Work. A reasonable question is whether GE took its new slogan too seriously because the transactions it engaged in certainly relied on imagining the results of operations it desired and developing the techniques to accomplish that goal.

On August 9, 2009, GE came clean and 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 companys reported earnings-per-share estimates.

In addition, the SEC charged GE with making up schemes to accelerate the recognition of revenue from its locomotive and aircraft spare parts business, to make the companys 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 SECs Division of Enforcement, in a statement. The facts of the case are taken from the complaint filed by the SEC against GE.¹

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 GAAP in order to hit the EPS estimates.²

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 fixed, long-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 derivativesin this case the swapscan 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 pretax charge to earnings.

According to court documents, days before GEs 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. As a result, GE overstated earnings in the fourth quarter of 2002 by more than 5 percent, and thereby met its revised consensus EPS estimates.

In the revenue recognition schemes, GE 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 GEs 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 it allowed its railroad customers to purchase the locomotives at their convenience sometime in the future.

In the case of the locomotives, the SEC said it found that in 2002 and again in 2003 managers had created ways to book sales before the end of December even though their customers were unwilling to buy the equipment until the new calendar year was under way. Each time GE managers arranged so-called bridge financing transactions in which financial firms agreed to purportedly purchase the locomotives and then resell them to GEs customers in the next quarter.

In December 2002, GE stored the locomotives and kept them fueled and idling to protect them against the cold. In one case, GE went so far as to promise a customer that it would cover as much as $4 million of tax liabilities that might result from using the financial intermediary. The 2002 transactions covered 131 of the 191 locomotives GE originally said it sold in that fourth quarter and overstated the business units revenues and profits by more than 39 percent. The next year, managers used essentially the same scheme, overstating the units revenues and profits by more than 16 percent.

That was not the case with the interest-rate derivatives. The SECs complaint describes internal e-mails in which a GE accountant worried about the extraordinarily big deal of possibly losing the right to use a loophole that sometimes allows companies to ignore losses in the fair value of assets. Weve got to fix this, the accountant declared. The problem stemmed from the fact that GE had effectively made bets on interest rates by writing more derivatives contracts than it needed to fix its interest expense from borrowing at floating rates. To remedy the accounting problem, a plan was proposed to retroactively change how the company accounted for derivatives.

When auditors said no, GE personnel altered the plan and then held a meeting, complete with a PowerPoint presentation reviewing the risks they were taking. They went ahead with the retroactive change, which allowed GE to avoid reporting a $200 million pretax charge that would have caused it to miss its expected earnings by 1.5 in the final quarter of 2002.

Question:

1. Did GE engage in earnings management? How would you make that determination given the facts of the case?