GE Restatement: What About the Auditors?

General Electric may have settled its accounting dispute with the Securities and Exchange Commission, but questions remain about repercussions for KPMG, the audit firm that gave its blessing to GE’s erroneous accounting.

The SEC settled its long investigation into GE’s accounting practices earlier this month, citing GE for four separate accounting violations related to derivatives and revenue recognition and fining the company $50 million. GE has wrestled with the accounting issue since 2004, and ultimately had to restate more than two years’ worth of financial results—results that repeatedly won clean audit opinions from KPMG when first issued.

The SEC and the Public Company Accounting Oversight Board will not say whether KPMG’s audit work in connection with the GE accounting problems also is under investigation. KPMG declined to discuss the matter as well. But the SEC complaint against General Electric gives plenty of cause for curiosity about whether KPMG auditors went just as astray as GE accountants.

One of GE’s accounting problems focused on a departure from Generally Accepted Accounting Principles to fix a mis-step in GE’s hedging program, where GE found itself over-hedged and tried to bend its hedge plan to fit accounting requirements.

The SEC complaint describes numerous exchanges between GE and its auditors over GE’s plan to alter the hedge program to achieve an accounting objective—namely, to avoid a $200 million pre-tax charge to earnings. The SEC said KPMG’s national office was consulted when hedge problems became apparent and confirmed the company’s worst fears: that the hedge approach had failed and the company had to disclose it.

GE came up with a workaround, and KPMG’s engagement team working with GE didn’t buy it, according to the SEC account. GE made some tweaks but stuck with the overall direction of the workaround, and ultimately issued its financial statements with a clean audit opinion from KPMG. “Prior to its utilization, neither GE nor its outside auditors sought to bring the new methodology to the … national office for its review,” the SEC wrote in its complaint.

Carmichael

An accounting failure does not automatically mean there was an audit failure, says auditing consultant Douglas Carmichael, a former chief auditor for the PCAOB. “Auditing standards have a provision that essentially says that,” he says. “The auditor gets reasonable assurance, not absolute assurance” that financial statements are fairly stated.

But the “reasonable assurance” threshold doesn’t fully explain why KPMG gave a clean audit opinion to GE’s failed accounting, at least for GE’s hedge accounting problems. “Reasonable assurance usually relates to a failure to detect something,” Carmichael says. “It doesn’t have anything to do with not reporting something once you know about it.”

“If the auditor audits financial statements and does the job properly in accordance with generally accepted auditing standards, they may be 100 percent correct and there may still be an error in there somewhere.”

—Bruce Pounder,

President,

Leveraged Logic

Carmichael stresses that he has no inside knowledge of what may or may not be happening in the enforcement wings of the SEC or the PCAOB, but he suspects KPMG’s audit work probably is under review. The enforcement processes “are not very public,” and they take a long time because of the number of appeals that can be pursued at various levels, he explains.

Carmichael adds that while the PCAOB has been faulted for having few major enforcement actions under its belt, that’s to be expected given how young the regulator is and how long enforcement actions take. He suspects a backlog of cases will eventually come to light as they work through the system.

Where It All Started

The PCAOB’s inspection program was just getting off the ground in 2003 as GE was pursuing its now-overturned hedge methodology. PCAOB inspection reports do not identify audit clients by name, but KPMG’s earliest inspection report (in 2003) makes no mention of audit issues that match the issues identified in the SEC’s action against GE. The inspection of KPMG audit work in 2004, however, which reviewed audits of 2003 financial statements, flags a departure from GAAP that looks a lot like the one described in the SEC complaint.

In 2004, a KPMG client identified as “Issuer D” merited a three-page description of accounting and auditing problems, and the leadoff complaint focuses on a departure from hedge accounting rules that echoes the SEC’s finding against GE. KPMG “noted during both the 2002 and the 2003 audits that the issuer did not develop the required documentation, but the firm failed to appropriately address the issuer’s improper accounting for the derivatives,” the PCAOB wrote in its inspection report.

Patricia Walters, an accounting professor at Fordham University, says an audit partner would probably not make a touchy judgment call on something as technical and as complicated as hedging without consulting with the national office first. In GE’s case, she believes the engagement team’s decision not to take the final call to the national office was probably a mistake. “It’s likely we’ll see action against the audit firm in response to that,” she says.

Martin

GE SETTLES

GE Announces SEC Settlement of 2002 &

2003 Accounting Issues

General Electric Company today announced that it had reached a settlement with the United States Securities and Exchange Commission (SEC), without admitting or denying allegations of any wrongdoing, which concludes the SEC’s investigation of accounting issues at GE. This settlement relates to four accounting matters in 2002 and 2003: the application of SFAS 133 to GE’s since-discontinued commercial paper hedging program and, separately, to certain swap derivatives where fees were paid or received at inception; a change in accounting for profits on spare parts in the commercial aviation engine business; and certain year-end transactions in the Rail business. GE has previously corrected for the effects of these matters in its financial statements in SEC filings made between May 2005 and February 2008. No further corrections are required. Under the terms of the settlement, the Company consented to the entry of a judgment requiring it to pay a civil penalty of $50 million and to comply with the federal securities laws.

The complaint alleges two of these errors, those relating to commercial paper hedging and Rail transactions, were intentional violations of the anti-fraud provisions of the securities laws, and the remaining two errors were negligent violations of the securities laws.

GE issued the following statement regarding the settlement:

“GE is committed to the highest standards of accounting. GE cooperated with the SEC over the course of its investigation, and GE and its Audit Committee conducted their own comprehensive review in conjunction with the investigation. The Company reviewed and produced approximately 2.9 million pages of e-mails and other documents to the SEC and incurred approximately $200 million in external legal and accounting expenses to ensure that all issues were addressed appropriately. We have concluded that it is in the best interests of GE and its shareholders to resolve this matter and put it behind us on the basis announced today, pursuant to which, consistent with standard SEC practice, we neither admit nor deny the SEC’s allegations. 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, as previously described in our SEC filings, including measures to strengthen our controllership and technical accounting resources and capabilities.”

In settling this matter, the SEC has acknowledged the efforts made by GE’s Audit Committee and senior management to address the issues arising during the course of this investigation and to implement appropriate remedial measures and control enhancements.

Source

General Electric (Aug. 4, 2009).

Alyssa Martin, executive partner at regional accounting firm Weaver and Tidwell, says Big 4 firms typically do consult the national office when a key technical issue is under scrutiny in the course of an audit, and the engagement team and national office would then work together to implement any response. “It’s not just the engagement partner’s call,” she says.

The ultimate approach, however, is a matter of firm policy, not auditing standards, Carmichael says. As part of their own approaches to quality control, firms decide for themselves when engagement teams would be required to consult with the national office on technical issues and how much weight the national office’s view would carry in the final audit opinion.

Walters

While the SEC complaint describes auditor behavior about hedge accounting, Walters is more curious about how KPMG missed GE’s revenue recognition violations—which were simply transactions booked in improper quarters to make GE’s results look good. Walters describes that behavior as a more “plain vanilla” accounting issue that auditors should catch.

“Regular audit procedures should have uncovered a revenue recognition issue like that,” she says. “I would like to see what the audit firm would say about why they didn’t discover that.”

Pounder

Bruce Pounder, president of accounting education firm Leveraged Logic, says the key to any audit scrutiny is whether auditing standards were followed and the audit delivered reasonable assurance. “That tends to be in the eye of the beholder,” he says.

“It’s always possible that the auditor did exactly what they should have done in living up to a standard that is not absolute perfection,” Pounder continues. “If the auditor audits financial statements and does the job properly in accordance with generally accepted auditing standards, they may be 100 percent correct and there may still be an error in there somewhere.”

Pounder says it’s hard to say whether KPMG will face any kind of enforcement action as a result of its GE audit work. “Sadly, this falls well within the range of what people aren’t willing to take action on,” he says. “As bad as this was, as blatant as this was, I don’t think anyone is going to do anything differently as a result of this.”