THE SPIRIT OF ACCOUNTING: GE: Tail wags the dog, as stockholders get pickup duty

In early August, the Securities and Exchange Commission announced the outcome of an investigation into allegedly fraudulent and deficient accounting by GE (formerly General Electric). The announcement revealed that GE had settled the charges by paying a $50 million fine.

According to legal custom, GE's officers neither admitted nor denied the violations. However, the press reported that the company had spent over $200 million on its own investigation. Given all the pieces, there is a solid basis for inferring that the alleged wrongdoing did indeed happen.

GREAT EXPECTATIONS?

According to the SEC's release and court documents, GE's managers engaged in deceptive accounting in four areas involving derivatives, hedging, and revenue recognition. The SEC suggested that, "The improper accounting allowed GE to avoid missing analysts' final consensus EPS expectations."

The court document shows the accounting personnel were driven to avoid coming up short. Indeed, the SEC release states that, "GE met or exceeded final consensus analyst earnings-per-share expectations (EPS) every quarter from 1995 through filing of its 2004 annual report. However, on four separate occasions in 2002 and 2003, high-level GE accounting executives or other finance personnel approved accounting that was not in compliance with GAAP."

We think GE management was letting the tail wag the dog. Analysts' estimates (which are really predictions, not estimates) are made and then GAAP results come out in due time (we avoid saying "actual" results because GAAP's many shortcomings keep reported earnings from revealing what actually happened). In a normal situation, we would expect a difference between expectations and reported results to focus scrutiny on the analysts who made the flawed predictions. After all, they didn't get the "right" answers. They should be responsible for explaining why their numbers differed from the company's.

In the topsy-turvy world at GE (and other places, for sure), it was the other way around. Because the results (based on total access to all relevant facts) weren't going to meet the analysts' predictions (based on highly limited access), real people inside GE decided to alter their reports to coincide with what the relatively uninformed analysts had generated.

Unfortunately, the settlement probably precludes additional disclosure by the SEC describing exactly why the behavior occur­red. However, this settlement does nothing to protect the miscreants against civil actions, including shareholder suits, to recover the $250 million and damages.

Our speculation is that this fraud wasn't perpetrated by second-level accounting and financial managers acting on their own. Instead, we lay blame at the feet of the chief executive, Jeff Immelt, and the chief financial officer, Keith Sherin, both of whom were at their respective helms when the alleged misdeeds occurred. Even if they didn't pull the actual triggers, they apparently created a tone at the top that elevated meeting forecasts above personal integrity, professional responsibility and compliance with federal securities laws. We think the GE board ought to dismiss these two without severance, whether they knew what was going on or not.

FOR EXAMPLE ...

One piece of the fraud is fairly easy to explain in our limited space. Specifically, GE's transportation division builds large, complex and expensive locomotives. The company had entered into contracts to build and deliver several hundred of them in 2002 through 2004. On the whole, this good news would be well received by the capital markets, because each unit carries a multi-million-dollar sales price and an enviable margin.

The fly in the ointment, however, was that poor macroeconomic conditions caused the buyers to postpone delivery. Delaying delivery out of 2002 into 2003 involved a hefty $223 million of revenue; delays out of 2003 into 2004 involved another $158 million.

With little more conscience (and far less imagination) than a Three-Card Monte dealer in Times Square, the accounting geniuses at GE came up with a plan to "sell" (wink, wink) the locomotives to an unnamed intermediary in 2002, so that revenue could be reported in that year. The intermediary agreed to "hold" these assets (wink, wink) and then "sell" them to the railroads when they were ready (wink, wink). Despite serious internal questions following the first set of "transactions" (wink, wink), the same deal was again executed at the end of 2003. This scheme is nothing other than the classic "bill and hold" dodge that emerald-green auditors are trained to look for from the first day on the job.

What makes the scheme even more preposterous is that the intermdiary did not have the capacity to take physical custody of the locomotives, so GE held onto them. Further, because of their complexity and the cold weather, GE had to keep the engines running and liquids topped up so they would be in good condition when the intermediary delivered them to the buyers (wink, wink).

Excuse us, but just how dumb do these managers think we are?

PICKUP DUTY

All of us have seen others doing it and many of us have to do it ourselves: Take the dog on a walk and carry along a little plastic sack for cleaning up what happens naturally.

In GE's case, the shareholders are the ones left holding the bag. The result of legal fees and the fine was a combined outflow of at least $250 million in cash. The irony is that the shareholders were the victims of the crime in the first place!

To fix this, first, the SEC and the legal system should force the costs to be recovered from the personal assets of those who committed the fraud, including those top managers who put the culture in place that motivated and then justified the fraud's occurrence, and the outside auditors who missed it. If and only if those assets are insufficient (to the point of bankruptcy and garnished wages) should shareholders be forced to step in and pay the remainder. An obvious additional outcome would be to terminate each and every person involved, including Immelt and Sherin, without severance and with a ban on holding any position in a public company. Why should they be allowed to pass the financial burden of their misdeeds along to those they not only cheated but also work for?

A second fix is more general, and that would be replacing quarterly reporting with monthly or even weekly reporting. In this specific case, the delayed deliveries really didn't change anything except the timing of the cash flows. There was no real economic problem, but pressure arose because of the artificial year-end cutoff date.

With more frequent reporting, two things would happen. First, analysts' predictions would wither in importance. More frequent access to reported numbers would reduce the uncertainty that drives the markets to consult these fortune tellers and soothsayers. Second, it would allow management to let good news unfold naturally, instead of tempting them to cram it into the last week of a quarter.

A MORE RADICAL SOLUTION

In addition to those fixes, another change would have avoided this loco problem completely. Specifically, we're talking about the revenue recognition practices applied to this situation.

GE had contracts to produce and deliver locomotives, and the buyers had agreed to take delivery and pay for them. It wasn't like GE was making the locomotives to put on a showroom floor, hoping someone would come along and buy them.

On the conceptual level, we suggest that GE could have been allowed to recognize revenue at the time each unit was finished. Debit receivable, credit sales, done. Delivery was a formality and a matter of convenience, not a crucial phase of GE's earning process. Note how this would have put everything out in the open and above board. Just the truth, the whole truth, and nothing but, and told in a way that everyone could understand.

ISN'T IT IRONIC ...

Unfortunately, compliance with GAAP often leads to financials that don't accurately report the economic truth. In this case, GE's managers had two frustrating choices: Comply with GAAP and describe the consequence in a note explaining that revenue was delayed, not lost, or concoct a half-baked scheme to produce the appearance that recognizable sales had occurred. In desperation, they exchanged their professional souls for reporting revenue a mere month or two earlier.

How much easier and more honorable it would have been to just tell the truth and live with the temporary shortfall below expectations! While we have sympathy for managers at GE and elsewhere for their frustration, we have none whatsoever for their decision to lie their way out of the dilemma.

Bottom line, without one or more of these reforms, shareholders of all companies, not just GE, will have no choice but to trail along after management with scooper in hand, ever ready to clean up the next mess.

Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authors' views are not necessarily those of their institutions. Reach them at paulandpaul qfr.biz.

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