Case 7-3 GE: “Imagination at Work”
Back on January 16, 2003, after more than 23 years, General Electric (GE) Co. decided to dump
its well-recognized slogan, “We Bring Good Things to Life,” and decided to spend more than
$100 million to launch a new campaign with the tagline, “Imagination at Work.” A reasonable
question is whether GE took its new slogan too seriously because the transactions it engaged in
certainly relied on imagining the results of operations it desired and developing the techniques to
accomplish that goal.
Without admitting or denying guilt, GE paid a fine of $50 million, and agreed to remedial action
related to internal control enhancements. “GE bent the accounting rules beyond the breaking
point,” noted Robert Khuzami, director of the SEC’s Division of Enforcement, in a statement.
The facts of the case are taken from the complaint filed by the SEC against GE.
The SEC uncovered the violations after conducting “risk–based” investigations at GE, in which
the government staffers identify a potential risk in an industry or at a particular company and
develop a plan to test whether the problem actually exists. In the case of GE, the SEC identified
potential misuse of hedge accounting as a possible risk area.
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 fixed, long-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.
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In the revenue recognition schemes, GE 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
In December 2002, GE stored the locomotives and kept them fueled and idling to protect them
against the cold. 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 percent. The next
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.
Questions
1. Review the SEC’s complaint against GE (see Note 1) and explain the specifics of the
company’s hedging transactions and why they violated GAAP.
According to the SEC’s litigation release,
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GE violated the accounting for swap rules that exist
under Financial Accounting Standards Board Statements of Financial Accounting Standards No.
133, Accounting for Derivative Instruments and Hedging Activities (“FAS 133”). FAS 133
governs the accounting for derivative financial instruments such as interest-rate swaps. It
generally requires that instruments meeting the definition of derivatives, including interest-rate
swaps, be recorded at their fair value, and that any changes in their fair value be reported in
In order for an issuer to qualify for hedge accounting, FAS 133 requires, among other things, that
the issuer comply with two principal requirements: (1) a documentation requirement and (2) a
specificity requirement. In connection with the documentation requirement, an issuer must create
The entity must follow the terms of this documentation throughout the life of the hedge and may
not substantively alter it. If the documentation is not followed, the entity loses the special hedge
FAS 133 also provides that to qualify for hedge accounting, the forecasted transactions must be
“probable” of occurring. FAS 133 provides that a “pattern” of failed forecasted transactions
could disqualify an entity from using cash flow hedge accounting for similar forecasted
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transactions. For GE, FAS 133 became effective on January 1, 2001. By this date, GE had
developed a methodology to hedge the variable interest rates it paid on the CP it issued. GE
divided the CP it expected to issue into groups or “buckets” based on the CP’s average maturity
dates (i.e., CP which matured between 8-74 days had an average maturity date of 30 days), and
GE’s hedge documentation contained a table describing the parameters of the CP buckets. More
specifically, the documentation for GE’s U.S. dollar CP stated: The maturity buckets are as
follows:
Bucket Weighted-Average
1-7 Day
2 Days
75-120 Day
93 Days
121-174
If, for a particular bucket of CP, the size of the interest-rate swaps exceeded the amount of CP
issued in a period, GE would be “overhedged,” meaning certain forecasted transactions (i.e., the
issuances of CP to be hedged) would not have occurred. In this situation, GE would have
failed forecasted transactions. From January 2001 through mid-2002, GE accounted for its CP
hedging program in a manner consistent with the fixed bucket parameters set forth in the table of
its hedge documentation.
The new approach violated GAAP, according to the SEC’s complaint, but allowed GE to
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preserve its use of hedge accounting for its CP program and to avoid recording what GE
estimated to be an approximately $200 million charge to pretax earnings.
2. Did GE violate the rules for revenue recognition (pre-2016-change) on the “sale” of
its locomotives? Explain.
In the case of the locomotives, the SEC found that in the fourth quarters of 2002 and 2003, GE
had improperly recorded revenue of $223 million and $158 million, respectively, for the sale of
locomotives to financial institutions (FIs).
The SEC’s complaint alleges that the six transactions were not “true sales” and did not qualify
for revenue recognition under GAAP.
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The error in making that change resulted in GE overstating 2002 net earnings by approximately
$585 million.
In alleging that GE’s decision to make internal pricing changes on a prospective-only basis did
not comply with GAAP, the SEC cited a call on March 27, 2002, involving senior GE corporate
accountants and members of the business unit.
3. Did GE engage in earnings management? How would you make that determination
given the facts of the case?
To avoid reporting swings in the value of those swaps in quarterly earnings, GE opted for
“cash flow” accounting that required it closely match the swaps to its borrowings. The
relationship between the two started to fall apart in 2001 and 2002, however, and GE
executives scrambled to fix the problem. In a December 2002 e-mail, an unnamed executive
asked “isn’t this an extraordinarily big deal?”
The company ultimately deviated from accounting rules to avoid reporting a $200 million
pre-tax hit to earnings and continue reporting profits that met analysts’ expectations. The
company fessed up in 2007, correcting earnings for 2001 through 2005.
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Such seemingly insignificant accounting moves collectively can prop up a company’s stock by
reassuring investors who are extraordinarily sensitive to volatility in earnings, said Charles
Mulford of Georgia Tech. Certainly GE executives were aware of their importance, agonizing in
e-mails over how to avoid changes in reported earnings and whether the SEC would notice.
“They might seem arcane and insignificant, but they impact earnings, the quality of earnings and
the sustainability of earnings,” Mulford said. “They all impact the share values.”
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In 2002 and 2003, reported end-of-year sales of locomotives that had not yet occurred in order to
accelerate more than $370 million in revenue; “GE personnel at the business level orchestrated
these transactions in order to improperly accelerate revenue recognition,” the SEC said, adding
that GE “admitted that the revenues and profit for the reported business segments containing the
year-end rail transactions were overstated by 8.8% and 14.6%, respectively, in the fourth quarter
of 2002 and overstated by 22.6% and 16.7%, respectively, in the fourth quarter of 2003″.
In a prepared statement GE explained its position as follows. “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
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