According to GE, the company produced 2.9 million documents, and spent $200 million over four years in legal and accounting fees, to cooperate with the SEC’s probe and conduct its own “comprehensive review” of the problems. In the second quarter of 2007, the company noted in a regulatory filing that it took disciplinary action against employees involved in the locomotive transactions, which included firing workers who “engaged in intentional misconduct.”
Despite its sterling reputation for financial management, GE also has long been the subject of charges from critics that its reliable earnings derived not from the natural smoothing effect of its diversified holdings, but its ability to use that complex structure — including financing arm GE Capital Corp — to manage earnings. “We have not used the words ‘earnings management,’ but we have said GE misapplied accounting rules so it could cast its financial results in a better light,” Bergers told CFO.
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 long, fixed-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 derivatives — in this case the swaps — can 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 pre-tax charge to earnings, noted the SEC. For months before, GE had struggled to solve its commercial paper hedge accounting issues with proposals based on its established accounting approach. But none of the ideas permitted GE to avoid “certain potentially harmful disclosures,” concluded the regulator.
According to court documents, days before GE’s 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, asserted the SEC. As a result, GE overstated earnings in the fourth quarter of 2002 by more than 5%, and thereby met its revised consensus EPS estimates, added the SEC in its complaint.
The fact that GE had not missed consensus estimates for the previous eight years “is signficant,” Berger told CFO. “The motivation [for the accounting change] was to increase earnings.”
In addition to reworking its accounting approach, the SEC charged that GE also improperly used the so-called shortcut accounting treatment for its swaps, which it was ineligible to use.
The revenue recognition schemes were a bit different, in that they 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 GE’s railroad customers in the first quarters of the subsequent fiscal years.”