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The AAO Weblog covers accounting issues and current events as they relate the practice of investment analysis.

May 6

Written by: Jack Ciesielski
5/6/2005 6:53 AM 

This morning GE issued a non-reliance 8-K on its 2004 financial statements. The culprit: incorrect application of the notoriously complicated Statement 133, "Accounting for Derivative Instruments and Hedging Activities."

There were three chief errors that GE's internal audit staff uncovered "in the course of a regularly scheduled audit."

- There were interest rate and currency swaps at General Electric Credit Corporation that included up-front fees paid or received - and the swaps amounted to about 14% of total borrowings at January 1, 2001, when Statement 133 became effective. At the end of 2004, they were about 6% of total borrowings.

On the first pass, GE treated the fees as immaterial. (The 8-K doesn't disclose the amount of the fees alone.) Auditors KPMG agreed with the treatment in their 2001 audit. By 2003, these kinds of swaps were mostly discontinued, but existing swaps retained the accounting treatment. The problem: because of the up-front fees, the fair value of the swaps was not zero at the initiation of the transaction - and 133 requires ongoing "effectiveness testing" of the hedge (to determine if it really is a hedge.)

GE didn't perform effectiveness testing. The filing doesn't specify the consequences of ultimately completing the testing, but if they're doing a restatement, you'd think that the testing showed that the swaps were not effective hedges. The consequences of ineffective hedges is that the changes in fair value of the hedging instruments should pass through earnings as they are revalued each period.

- Second issue: there was a a hedge accounting position linked to a portfolio of assets consolidated by General Electric Credit Corporation in July 2003 when FIN 46 (Consolidation of Variable Interest Entities) was implemented. The portfolio's assets amounted to 2% and 1% of GE's total assets at consolidation and at year end 2004, respectively. Not an insignificant-sized portfolio, when you consider the size of GE's asset base.

GE engaged in "interest rate swaps in 2003 to adjust the economic yield on these newly-consolidated fixed-rate assets from a fixed to a floating rate." Once again, the firm did not perform subsequent effectiveness testing. The internal auditors found something that the initial recorders and auditors missed on the first go-round: the prepayment penalties in the underlying assets were not properly factored into the associated swaps. If they had been, effectiveness testing wouldn't have been required. Because they didn't reflect the penalties, the testing was required; it wasn't executed. And here we are.

- GE is less descriptive about the other errors, saying only that the internal audit "identified other errors under SFAS 133 with respect to other aspects of certain swaps and other derivative instruments. Adjustments to correct the accounting for these transactions also are included in our restated results of operations. We do not believe these other adjustments are material, individually or in the aggregate, to our financial position or our results of operations for any reported period."

Toting up the restatement, GE figures that "the cumulative effect of these changes is a non-cash earnings increase of $381 million from 2001 through the first quarter of 2005, less than six-tenths of one percent of GE's earnings over this period." It mentions that the restatement mattered little on an annual basis, but on a quarterly basis, restatement became necessary.

It's a happy restatement for GE. You can blame the complexity of Statement 133 (they did) or you can blame the auditors (they insinuated). Bottom line, it's a messy set of transactions that are complex in and of themselves -and so will be the accounting for them. GE is a crackerjack outfit - and they had problems. Do you wonder how many firms that have control weaknesses in the area of "qualified personnel" have gotten this wrong as well - in the opposite direction?