With General Electric's (GE) stock price falling to new lows, managers at GE's Transportation Systems pretended they had sold more than 100 locomotives that were actually running at idle on GE property in the December cold of 2002, the Securities & Exchange Commission charged on Aug. 4.
The scheme was among four sets of accounting misdeeds by GE in 2002 and 2003 that the SEC described in a lawsuit it made public as part of a settlement in which the conglomerate agreed to pay $50 million in fines. The suit alleged that two sets of transactions were intentionally designed to defraud investors. While GE has already corrected its financial reports in a series of restatements it made during the SEC's multiyear investigation, the details of the manipulations are new and add another black mark to GE's once-sterling reputation. The revelations would seem to confirm suspicions many investors had developed about how the company beat or met analysts' earnings estimates every single quarter for a decade from 1995 through 2004.
"They were trying to manage earnings and it involved bending the rules and breaking them," said Paul Miller, an accounting professor at the University of Colorado at Colorado Springs. "Shame on them."
The Fairfield (Conn.)-based company issued a written statement acknowledging that "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." GE said it produced 2.9 million pages of e-mails and other documents for the SEC and spent $200 million to hire outside legal and accounting teams to resolve the issues. Jeffrey Immelt became CEO in 2000, taking over from longtime Chairman and CEO Jack Welch. (Welch is a BusinessWeek columnist.)
"Bridge Financing" Sped Sales Dates The SEC's lawsuit did not name any individuals or other companies involved in the matters. The agency's announcement said the action concludes its "investigation with respect to the company."
In the case of the locomotives, the SEC said it found that in 2002 and again in 2003 managers had concocted ways to book sales before the end of December even though their customers were unwilling to buy the equipment until the new calendar year was under way. Each time GE managers arranged so-called "bridge financing" transactions in which financial firms agreed to purportedly "purchase" the locomotives and then resell them to GE's customers in the next quarter. Accounting rules generally say that companies cannot count sales unless customers have taken title to products and assumed the risks and rewards of owning them.
In December 2002, GE stored the locomotives and kept them fueled and idling to protect them against the cold, the SEC said. In one case, GE went so far as to promise a customer that it would cover as much as $4 million of tax liabilities that might result from using the financial intermediary. The 2002 transactions covered 131 of the 191 locomotives GE originally said it sold in that fourth quarter and overstated the business unit's revenues and profits by more than 39%. The next year, managers used essentially the same scheme, overstating the unit's revenues and profits by more than 16%.
GE Shed a $200 Million Pretax Charge The three additional sets of breaches involve hiding losses from interest-rate derivatives, improper accounting for hedging transactions, and a complex effort to offset the consequences of accounting that had distorted profit margins that GE reported from selling aircraft engines. The SEC did not charge GE with deliberately breaking rules on the hedging and aircraft engine transactions.
That was not the case with the interest-rate derivatives. The lawsuit described internal e-mails in which a GE accountant worried about the "extraordinarily big deal" of possibly losing the right to use a loophole that sometimes allows companies to ignore losses in the fair value of assets. "We've got to fix this," the accountant declared. The problem stemmed from the fact that GE had effectively made bets on interest rates by writing more derivatives contracts than it needed to fix its interest expense from borrowing at floating rates. To remedy the accounting problem, a plan was proposed to retroactively change how the company accounted for derivatives.
When auditors said no, GE personnel altered the plan and then held a meeting, complete with a PowerPoint presentation reviewing the risks they were taking. They went ahead with the retroactive change, which allowed GE to avoid reporting a $200 million pretax charge that would have caused it to miss its expected earnings by 1.5¢ in the final quarter of 2002, the SEC said.
GE shares on Aug. 4 gained 10¢ to finish at 13.82, down 51% over the past 12 months. The stock traded as high as 60 in 2000. In March 2009, Standard & Poor's lowered GE's credit rating from AAA to AA+. (S&P, like BusinessWeek, is a unit of the McGraw-Hill Companies (MHP).)