Accounting Investigation Adds to Challenges Facing GE

There is an old joke about an executive looking to hire a new accountant. He asks each candidate: “What is one plus one?” The winner answers: “What do you want it to be?”

General Electric disclosed on Jan. 24 that the Securities and Exchange Commission had begun an investigation of the company’s accounting practices. The announcement most likely means there will be a deep dive into the conglomerate’s books and records, a process that will take months — if not years — to resolve. With the company’s stock down more than 40 percent the last 12 months, the uncertainty of an accounting investigation will only exacerbate the challenges facing John L. Flannery, the new chief executive, as he seeks to reorganize the company.

The SEC’s efforts to aggressively stop accounting problems stems from the history of companies like Enron and WorldCom, where small steps to burnish the financial statements burgeoned into frauds that took down the companies, ended in thousands of job losses and cost shareholders billions.

How this latest accounting issue at GE came to light was a bit odd. On a conference call last week discussing the company’s $9.8 billion loss in its most recent quarter, Jamie S. Miller, the chief financial officer, dropped a little tidbit that “we have been notified by the SEC that they are investigating the process leading to the insurance reserve increase and the fourth-quarter charge as well as GE’s revenue recognition and controls for long-term service agreements.”

It’s not easy to slip an investigation of potential accounting issues past analysts, and the stock price dropped another 2.7 percent that day after the disclosure.

GE vowed to cooperate with the investigation, just like every company does, and Miller said that “there is nothing here that I am overly concerned about.”

But accounting investigations tend to take on a life of their own. They require a company and its outside auditor to explain a wide range of decisions that raise questions about the propriety of its internal controls. And as with any investigation, where the SEC starts is not necessarily where the agency will end up if other issues come to the surface.

A starting point will be the insurance charge that GE said will total $15 billion over seven years because of issues estimating the costs of long-term care and other policies. That is a substantial underestimation. The SEC will want to know whether the failure to recognize the losses earlier was a means to keep the company’s earnings afloat, and why it took this long to disclose them.

Revenue recognition related to service agreements is an area of concern for the SEC because aggressive accounting can hide a deterioration in a business line. Some companies book revenue early, robbing from the future to make the present look better in the hope that things will turn around.

The SEC rule prohibiting accounting fraud is quite broad: “No person shall directly or indirectly, falsify or cause to be falsified, any book, record or account.” One limitation is that any misstatement has to be “material,” although the size of GE’s insurance charge and the importance of its service agreements likely mean any problems uncovered will meet that standard.

This is not the first time GE has dealt with questions about its accounting. In 2009, the company settled civil fraud and accounting charges with the SEC for using improper methods to steadily increase its reported earnings to meet or exceed the consensus earnings estimates of analysts and avoid any negative results. GE agreed to pay a $50 million penalty as part of the settlement, a substantial price for smoothing out earnings to remain in the good graces of investors.

Accounting fraud goes to the heart of the markets. Investors rely on financial statements to assess the future prospects of a company and expect one plus one will equal two. Any indication that the numbers were fudged puts at risk the trust investors have in management, further damaging an enterprise like GE that is already dealing with a host of challenges.