Post-Mortem: GE’s $50 Million Accounting Glitch

Anyone in the financial reporting world seeking further proof of just how complex hedge accounting can be, please review General Electric’s latest corporate filings.

Earlier this month GE announced that it had finally settled a long investigation by the Securities and Exchange Commission into its accounting practices. When all was done, GE had restated more than two years’ worth of financial results, paid a $50 million fine to the SEC, spent another $200 million on its own legal and investigation costs, and swallowed a large helping of bad publicity.

At the heart of it all was sloppy hedge accounting and revenue recognition—two of the most complicated, prescriptive areas in U.S. Generally Accepted Accounting Principles. While GE admitted no guilt as part of its settlement, the SEC made four specific allegations against the company: two related to hedges, and two related to revenue recognition.

On hedging, the SEC said GE improperly changed the way it treated its commercial paper hedges to avoid reporting a $200 million loss and some potentially ugly disclosures. GE also applied a short-cut method that it didn’t qualify to use, the SEC said, which allowed the company to smooth earnings when it should have been reporting more volatility.

As for revenue recognition, the SEC said GE staff orchestrated six sham transactions to generate fourth-quarter revenue of $223 million in 2002 and $158 million in 2003. The SEC also said GE overstated earnings in 2002 by approximately $585 million via improper changes to its accounting for the sale of aircraft engine spare parts.

For its part, GE said in a statement that the errors “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.”

The conglomerate decided to settle the SEC probe because it is “in the best interests of GE and its shareholders” to put the nagging matter behind it.

Sherman

In several filings through early 2008, GE restated its results for 2002, 2003 and the first half of 2004 to correct the various misstatements. In the larger picture, however, GE’s missteps were nothing special; GE was only one of thousands of businesses that restated financial results in the post-Sarbanes-Oxley restatement wave of 2005 to 2007, according to David Sherman, accounting professor at Northeastern University.

Peter Kyviakidis, managing director at the consulting LECG, says GE’s original hedging program was fine. Instead, the company encountered “fundamental problems” with the specific details, as GE’s actual hedges began to deviate from what it first proposed to do.

“If you develop a problem, it’s your problem and you’ve got to live with it. GE didn’t do that. The documentation is your constitution and there’s not a lot of room for amendment.”

—Dwayne Cook,

Practice Leader,

Tatum

What went wrong? Overall, GE was funding the purchase of long-term fixed assets via short-term commercial paper, which creates an exposure to fluctuations in interest rates. “That’s fine, because it can be hedged,” Kyviakidis says—but GE ultimately purchased less commercial paper than it had planned, and didn’t cut its purchase of derivatives accordingly. That created a mis-match in its hedging plans, and that was the error.

GAAP, most notably Topic 815 on derivatives and hedging in the Accounting Standards Codification, says companies can get favorable hedge accounting treatment for legitimate hedges by carefully documenting what they plan to do at the outset of the hedge. The documentation must meet some specific criteria outlined in the accounting rules, Kyviakidis says. “GAAP is trying to guard against someone saying they are hedging when in reality they’re speculating using derivatives,” he said.

When GE didn’t follow its plan exactly and created a mis-match, “They became over-hedged,” Kyviakidis says. “They had excess derivatives relative to the commercial paper to be hedged. They had something hedging nothing else. When that happens, you can no longer use hedge accounting.”

Cook

That, in turn, means marking instruments to fair value and reporting all the related gains and losses to earnings, which creates unpleasant volatility, says Dwayne Cook, practice leader for consulting firm Tatum. GE tried to evade that prospect by changing its hedge methodology, and that’s a no-no, Cook says.

The SEC complaint describes a bevy of activity at GE approaching year-end to figure out how to correct the over-hedge problem. Ultimately, GE tried to rationalize that its original approach didn’t really mean to match hedge transactions precisely, but within “buckets” or ranges.

HEDGING/REV REC VIOLATIONS

Below is an excerpt from the Securities and Exchange Commission’s complaint that explains GE’s improper accounting practices:

Improper Treatment of CP Hedging

In the period from January 2001 though December 2006, GE used hedge

accounting to account for interest rate swaps held for the purpose of hedging interest rate

exposure on its CP issuances, resulting in smoother reported earnings. In late 2002 and

early 2003, GE learned that continuing to apply its existing hedge accounting method for

its CP program would require it, among other things, to report certain fluctuations in the

value of its CP interest rate swaps. Rather than reporting these fluctuations, however, GE

changed the hedge accounting approach it used in a way that it knew or was reckless in

not knowing did not comply with accounting rules.

Specifically, in early 2003, GE changed its CP hedge accounting approach

(1) to avoid reporting a disclosure that might have led to the loss of hedge accounting for

its entire CP program and (2) to avoid recording what GE estimated to be an

approximately $200 million pre-tax charge to earnings. For months prior, GE had sought

to solve its CP hedge accounting issues with proposals based on its established CP

hedging approach. None of the proposals permitted GE to avoid certain potentially

harmful disclosures. Just days before GE’s quarterly financial data was to be released in

early 2003, however, GE developed an entirely new approach that, when applied

retroactively to transactions that occurred months before, allowed GE to obtain the

desired accounting results and avoid required disclosures that GE personnel feared could

be harmful. The new approach violated GAAP. As a result, GE improperly overstated

earnings in the fourth quarter of 2002 by an amount in excess of 5 percent, and thereby met its

revised consensus EPS estimates. From 1995 through December 31, 2004, GE had met

or exceeded final EPS expectations every quarter, in some cases after downward

revisions during the quarter.

Application of the new approach resulted in the publication of materially

false statements and materially false omissions in GE’s Form 10-K filed with the

Commission in March 2003 for fiscal year 2002.

Improper Recognition of Revenue From

Locomotive “Bridge Financing” Transactions

In the fourth quarters of 2002 and 2003, GE improperly recorded revenue

of $223 million and $158 million respectively for locomotives purportedly 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 six transactions were not true sales and did not qualify for revenue recognition under

GAAP. GE personnel at the business level orchestrated these transactions in order to

improperly accelerate revenue recognition. A member of GE’s corporate accounting

group approved the accounting for these transactions despite learning that GE maintained

significant obligations that: (1) suggested that the risks of ownership for the locomotives

had not passed and (2) should have precluded revenue recognition under GAAP.

Source

Securities and Exchange Commission vs. GE (Aug. 4, 2009).

“The key is the documentation at the front,” Cook says. “If you develop a problem, it’s your problem and you’ve got to live with it. GE didn’t do that. The documentation is your constitution and there’s not a lot of room for amendment.”

So Much for the Short Cut

The SEC said GE also noticed in early 2003 that it was using a short-cut method permitted in accounting rules as long as some strict criteria is met, but the company didn’t meet the criteria closely enough to use the method because it was paying certain fees on its interest-rate swaps. The company quit entering swaps that involved fees going forward, but didn’t go back and correct the accounting of the past, the SEC said.

Cook says the loss of the short-cut method is onerous. “If you’re not eligible for the short-cut method, you’re immediately relegated to the long-haul method, which means documentation initially and then subsequently each period,” he explains. That likely would lead to a change in earnings and greater volatility, an outcome GE tried to avoid, he adds.

Kyviakidis

On the revenue side, Kyviakidis describes the infractions as fairly straightforward: Executives were pushing revenue forward into future quarters. “It seemed like a conscious effort to pull revenue forward because they wanted to make the numbers for certain quarters,” he says.

Sherman says the SEC actions against GE, and earlier against Fannie Mae for similar accounting errors, demonstrate just how prescriptive GAAP can be and how changing interpretations led to the unprecedented wave of restatements. The settlements also provide a reminder of where the United States could be heading in its drive to eventually adopt International Financial Reporting Standards.

“This is an important policy issue,” Sherman says. Under U.S. GAAP, the accounting is nightmarish. But under IFRS, “it would be totally acceptable,” he says. “A lot of the things GE and Fannie Mae did probably would have been considered reasonable under a principles-based approach.”

Fannie Mae made an historic $10.8 billion restatement in 2005, that Sherman worked on while service as an academic fellow at the SEC. Of that $10.8 billion total, $8.4 billion came from snafus in hedge accounting. Financial statement preparers, auditors, investors, and regulators alike all have acknowledged repeatedly that accounting rules related to hedging and revenue recognition are in desperate need of a makeover.

Like a mirage in the desert, that makeover is on the horizon. Hedge accounting rules ultimately will change as the United States slowly converges GAAP with IFRS. Until then, however, GAAP applies—and GE is paying the price for stepping beyond its boundaries.