Wednesday, August 5, 2009

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.

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