More on GE Accounting Fraud Allegations--Smooth Flying on Jet Engines

The SEC recently settled allegations of fraudulent accounting with GE. More details:

GE was worried that volatility in its revenues would wreck its plans to meet earnings expectations. The SEC alleged that GE engaged in complex hedge accounting manipulations to smooth earnings, and in a scheme to further smooth profits in its aircraft engine business.

The earnings smoothing was done by hiding losses from interest-rate derivatives, improper accounting for hedging transactions, and a messy scheme to smooth profits in its aircraft engine business.

The SEC did not charge GE with deliberately breaking rules on the hedging and aircraft engine transactions.

The SEC’s lawsuit referred to internal e-mails in which a GE accountant said "we've got to fix this" about the "extraordinarily big deal" of possibly losing the right to use legitimate accounting to allows companies to ignore losses in the fair value of derivative assets.

GE had bet on interest rates by writing more derivatives contracts than it needed to hedge its floating rate debt exposure. The SEC claims that GE retroactively changed how it accounted for derivatives, but the plan was rejected by KPMG, its external auditors. The Sec claims that GE then altered the plan and then went ahead with the retroactive change anyway. This allowed GE to avoid reporting a $200 million loss.

More on GE Fraud--Locomotives on a Bridge

Additional information of GE's settlement with the SEC over bad accounting.

SEC says that in 2002 and 2003 GE booked locomotive sales before the end of their December 31 fiscal year even though they had not delivered the equipment until the next year. They arranged bridge financing in which finance companies purchased the locomotives and then resold them to GE's customers in the next quarter. This violates the “risks and rewards” guidance in revenue recognition accounting standards as the risks and rewards of ownership of the locomotives remained with GE and did not transfer to its ultimate customers.

GE promised at least one customer that it would reimburse about $4 million of tax hits that would arise using the financial intermediary. In 2002, 131 of the 191 locomotives GE originally said it sold were not actually sold. This overstated revenues and profits by more than 39%. In 2003, using the same manipulation, GE overstated revenues and profits by over 16%.

As part of the locomotive manipulation, GE asked that the financial intermediaries avoid explicitly stating in their invoices that GE was paying for the costs of storage and insurance for fear of negatively impacting GE’s revenue recognition in the quarter.

American Bankers' Association Criticizes FASB, IASB over mark to Market Changes

The American bankers Association (“ABA”) has written to Robert Herz, Chairman of the FASB and Sir David Tweedie Chairman of IASB, about their concerns around the process being taken on the FASB and IASB projects relating to financial instruments.

The ABA has lobbied against mark to market accounting for years and their response is no surprise.

The ABA says that the changes that the FASB and IASB are considering represent the most significant accounting changes the ABA has ever experienced. The ABA encourages the FASB and IASB to make such changes only "with utmost caution and the appropriate level of due process to correspond with the magnitude of the changes."

The ABA agrees that a certain amount of change is urgently needed, but that the FASB and IASB direction may cause significant disruption, with both preparers and users of financial statements.

They state that rule-makers must be very careful in this effort to ensure that any changes:
1) represent solid and meaningful change that is valuable and understandable to financial statement users;
2) focus on the business models used by entities that prepare the financial statements, and
3) can be implemented and maintained at a reasonable cost.

Other points made:

• The rapid paces at which both organizations are working, as well as the paths being taken, are causing some to question whether there is due process in evaluating these important issues.
• Some bankers also question whether such efforts are driven by a search for simplicity, transparency, and accuracy or by an appetite to expand fair value accounting, no matter the implications.
• A major concern is that the current directions in which the FASB and IASB are moving appear to be similarly requiring more mark to market accounting (MTM) within the financial statements, more capital for many existing banking activities, and more operational challenges to comply with these rules for banks of all sizes.
• The cost of accounting compliance puts continued participation in certain market activities at risk for some smaller institutions.
• Concern over the current divergence between the FASB and IASB proposed models and time frames for completion. The IASB plans to finalize its accounting standard in 2009, and the FASB's completion date will be subsequent to that date. In such case, the FASB will have only one of two choices: (1) to follow the IASB model – which will not provide U.S. companies with appropriate due process for providing input, or (2) a lack of international convergence – which should be avoided.

ABA says that the IASB appears to be solving the accounting puzzle on a piecemeal basis, which may result in pre-determining the outcome for subsequent parts of the puzzle that may not fit.

ABA feels that it is extremely important that new standards be developed jointly by the FASB and IASB, with proper due process and open consultation with a wide range of constituents that ensures a holistic review.

ABA's points for consideration when making substantial changes to the accounting model:

• Serious consideration must be give to field testing proposals prior to implementation, and sufficient transition time must be provided.
• Regulatory accounting rules should be consistent with GAAP.
• Accounting changes must meet a “costs vs. benefits” test.
  

Trains that Ran Ahead of Time: GE Takes Big Reputation Hit and pays SEC Fines

General Electric broke accounting rules to meet or beat earnings expectations
SEC claims they intentionally defrauded investors

GE has paid $250-million in fines and legal costs to settle a claim by the SEC that they intentionally defrauded investors.

The SEC fined GE $50-milion and lawyers and accountants advising General Electric on the fraud settlement earned $200-million on “external legal and accounting expenses” from the case.

The SEC slammed GE for almost ten years of earnings manipulation through accounting practices. GE consistently beat analyst consensus estimates by a few cents a share in nearly every quarter.

The SEC stated that “high-level GE accounting executives or other finance personnel approved accounting that was not in compliance with Generally Accepted Accounting Principles.

"GE bent the accounting rules beyond the breaking point," said Robert Khuzami, Director of the SEC's Division of Enforcement. "Overly aggressive accounting can distort a company's true financial condition and mislead investors."

David P. Bergers, Director of the SEC's Boston Regional Office, added, "Every accounting decision at a company should be driven by a desire to get it right, not to achieve a particular business objective. GE misapplied the accounting rules to cast its financial results in a better light."

There is always a risk that companies that take pride in consistently being slightly above market or analyst predications are not unlike Bernie Madoff’s fraudulently consistent positive returns on his portfolio over a long periods. GE has been in that slightly better than expected position for years and the SEC, to its credit, hit them hard for diddling with the quarterly earnings amounts.

Some of the years in question were presided over by Jack Welch, some by Jeffrey Immelt. The reputation of those leaders and GE takes a serious setback with the SEC’s actions.

The SEC found the accounting irregularities through a risk-based investigation of GE’s accounting. Their first clue was wrong hedge accounting, and the case developed from there to full blown fraud investigation.

The SEC plowed through millions of emails. Some of the smoking guns found by the SEC included the following statements:

• “How do we intend to deal with the SEC “one strike and you’re out” position? Doesn’t this mean that potentially we can no longer qualify for cash flow hedging??? Urgent that you find disclosures of others who have had cash flow failures. Isn’t this an extraordinarily big deal?”
• “I just went back to the SEC speech on this point, and don’t see any flexibility whatsoever. We’ve got to fix this.”
• “this was the one to go with until today . . . but when the initial quantification got finished today, it showed a $(200MM) or bigger hit would have to be considered”
• “[auditors] . . . looking into this, and might struggle to agree with this”
• a senior accountant in GE’s corporate accounting group sent a powerpoint describing GE’s outside auditor’s view that, if GE’s practice of recognizing margin on spare parts pursuant to RAM “Was Observed and Challenged [it is] . . .Virtually Assured We Would Lose.”
• A document stated that...“accounting justification [was] crumbling” based on expected GAAP changes
• A powerpoint presentation by a GE accountant implied that a change could be accomplished without having to make a disclosure. “$1 billion unexplained balance in GE’s [deferred charge balance] could draw the attention of the SEC and would not survive.”

The alleged misstatements:

• improper application of the accounting standards to GE's commercial paper funding program to avoid unfavorable disclosures--estimated approximately $200 million pre-tax charge to earnings
• sales of locomotives that had not yet occurred to accelerate more than $370 million in revenue
• improper accounting for sales of commercial aircraft engines spare parts increasing earnings by $585 million.

GE neither admitted nor denied the allegations and said it had co-operated with the SEC and revised its financial statements. Civil suits may still be launched against some individuals.

The SEC’s complaint does not implicate either Welch or Immelt, or GE’s CFO.

Recently Immelt has ended earnings guidance for analysts. GE had an unexpected earnings miss in April last year, sending its stock into a pre-financial meltdown slump from a 2007 high of over $40 to about $26, before the intraday meltdown low of under $6.

FASB, IASB Support Moving to Direct Method For Cash Flow

As the FASB and IASB consider their proposed overhaul of financial statement presentation, one of the
significant changes would be the utilization of the direct method
rather than the indirect method for calculating cash flows.

The requirement to use the direct method is part of the proposed
changes that the two boards introduced in Discussion Paper (DP) No.
1630-100, Preliminary Views on Financial Statement Presentation.

The boards are planning to discuss the proposal in the near future, as
part of a broader discussion on financial statement presentation. In
this paper, the boards are advocating greater use of the direct method
of calculating operating cash flows.

Under the direct method, companies would present separately the main
categories of their operating cash receipts, such as cash collected
from customers, and operating cash payments, such as cash paid to
suppliers to acquire inventory. This approach is also known as the
income statement method because it requires companies to compute the
net cash provided by operating activities by adjusting each item in
the income statement.

Currently, most companies use what is known as the indirect method, by
reconciling profit or loss or net income to net operating cash flows.

Both U.S. GAAP and IFRS permit both the direct and indirect methods of
presenting operating cash flows. However, in DP No. 1630–100, the
boards said a major deficiency of the indirect method is that it
derives the net cash flow from operating activities without separately
presenting any of the operating cash receipts and payments.

SEC Comment Letters--In Your Mailbox Soon?

The accounting firm Crowe Horwath has published an article Recent Trends in SEC Comment Letters--Reproduced in its entirety below.

In December 2008, the Securities and Exchange Commission (SEC) staff indicated at the American Institute of Certified Public Accountants’ (AICPA) National Conference on Current SEC and PCAOB Developments that they would be conducting targeted reviews of fair value, other-than-temporary impairment (OTTI) of securities, and other asset impairments. As a result, several recent examples of SEC staff comment letters on periodic filings (Form 10-Qs and 10-Ks) have a clear focus on these issues.

Following are some general themes present in comment letters from the SEC staff on recent filings that might be helpful for registrants to consider as they prepare periodic filings. Management should carefully review their company's accounting policies as well as related financial statement and management’s discussion and analysis (MD&A) disclosures related to these issues.

Accounting
OTTI of Securities
The SEC has:

• Asked registrants to justify why securities with fair values significantly below cost are not considered to be OTTI.
• For securities with ratings of "default" or "speculative," the SEC has asked how management determined that an adverse change in cash flows had not occurred.
• Challenged registrants on whether the losses for sales of securities after a period end should have been recognized in the prior period.
• Asked registrants to provide specific information about securities with significant unrealized losses.
• Requested information includes the specific issuer and name of each security; type of underlying collateral, credit rating, severity, and duration of the unrealized loss; and how the financial condition and near-term prospects of the issuer were considered when determining that no OTTI was present.

Securities/Other
The SEC has asked registrants to:

• Provide implied discount rates used in determining fair value of securities when using Level 3 inputs (in accordance with the guidance in Financial Accounting Standards Board Staff Position 157-3 (FSP FAS 157-3), “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active,” and FSP FAS 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly”).
• Reconcile the cash flows used to determine fair value with the cash flows used to assess OTTI.
  Indicate the systems and controls used to validate prices received from third parties when valuing securities.

Goodwill and Other Intangible Assets
The SEC has commented on:

• Implied control premiums used to determine fair value of reporting units for purposes of step one of goodwill impairment tests. Assumptions used to determine fair value must be supportable and should not contradict observable data about recent transactions.
• The lack of support for a reasonable period in the context of determining market capitalization of a reporting unit.
• The lack of support for assumptions used when determining the fair value of an intangible asset – for example, when a multiperiod earnings approach has been used.

Presentation and Disclosure

Loans and the Allowance for Loan Losses
The SEC has:

• Asked registrants to consider more disaggregated disclosure about loan portfolios – for example, providing disclosures by exposure to subprime, alt A-paper, or other relatively high-risk loans.
• Commented on disclosing reasons for changes (or lack thereof) in general loan reserves considering changes in credit risk.
• Commented on presenting the basis for each risk category and the method for determining the loss factor applied to each category. It has asked companies to specifically identify how historical loss trends were adjusted based on current factors.
• Asked registrants to explain reasons for directional inconsistencies in loan-loss allowances – for example, when impaired loans increased but specifically identified reserves decreased.

Securities
The SEC has requested:

• More disclosure of reasons for transfers into and out of the Level 3 category and more robust discussion of how fair value was determined when classified as Level 3.
• Support for securities being presented as Level 2 that appear to require Level 3 classification based on other disclosures.

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