FEW FATES WERE worse than missing your numbers at General Electric.
The conglomerate was performance-driven and had a thick top-down management structure. Executives assigned targets to underlings, rather than lower-rung workers passing information up the ladder, so projections were based on market realities.
Managers were expected to hit those targets at the end of every quarter, and anyone who came up short scrambled to cover their required contribution to feeding Wall Street’s expectations. Since the Welch years, GE had rarely missed a quarter’s projections, and that wasn’t an accident.
GE Capital’s enormous base of assets provided the rest of the conglomerate with plenty of chips to cash when needed. If the quarter was looking light, something could simply be sold—a building, a parking lot, an airplane, or anything else in the cornucopia of GE holdings—for a quick profit.
For the divisions, the work was a little more intense. As one former senior executive told it, there often wasn’t much downtime after Thanksgiving, as long hours were required to make sure everything was getting booked by the end of the year.
Some GE workers didn’t spend New Year’s Eve with family or friends. Instead, they were at their desks in half-full but bustling offices. Food and libations were brought in, but not for a party: workers needed to be there to process last-minute changes and orders.
The end of the year was a time to push. The Healthcare business might need to make an eleventh-hour call to a hospital CFO to make a quick sale of an MRI system or other equipment, priced to move. Sometimes late sales like this created a mad rush to get the ordered equipment out on a truck so it could be recorded as a sale before midnight struck and the accounting year officially ended.
In GE’s entertainment division, staff accountants tracked big-budget movies to see if they were living up to projections, especially as the all-important quarter drew to a close. Movies produced by Universal were assets as far as GE’s accounting was concerned, merely investments on a balance sheet. Accountants totted up the expected value of a motion picture before it was released in theaters, subtracting the cost of production from the box-office revenues they expected to take in. But if a bad review, or slower than anticipated ticket sales, reduced the value of an asset, that change to the estimated value of the film the company owned had to be reflected on the books.
That had been the worrisome fate a couple of years earlier for King Kong, a remake of the Hollywood classic that had a star-studded cast and was directed by Peter Jackson, fresh off his success with The Lord of the Rings. The studio had expected a blockbuster, and they had spent like it. With a budget of more than $200 million, King Kong was one of the most expensive films ever made.
Critics were kind, but audiences were not, and the movie, while profitable, was pulling in far less than GE had estimated when it assigned a value to the film on its books. To the accountants, the carrying value of the movie needed to be adjusted, a move that would hurt GE’s profits. When the finance staff warned their bosses about the charge, they got an unexpected response: don’t make the adjustment.
The group was in a pickle. They couldn’t simply pretend that the movie was going to suddenly meet its gargantuan expectations; they knew that the number would have to be adjusted downward eventually. So a team gathered to brainstorm ideas to get out of the situation. The solution they came up with: releasing an extended-length DVD of the movie.
The rationale was that an extended-length DVD would be hugely popular with King Kong’s biggest fans, and it also was projected to rake in profits that would cover enough of the shortfall at the box office. With these new projections, GE wouldn’t have to lower the value of the franchise. It would avoid the need to take a charge and tell investors that its movie-making hadn’t been as profitable as expected.
These sorts of tricks were legitimate under accounting rules, GE employees told themselves, and auditors, including the independent auditors from KPMG, had signed off on them. Auditors from the outside accounting firm worked in tandem with members of the Corporate Audit Staff to vet the handling of the company books. Finance workers at the company noticed that the KPMG staffers they worked with directly tended to be more sympathetic to GE’s accounting decisions than their peers in the national office.
In 2007, other parts of GE’s accounting caught the attention of a less sympathetic set of eyes. In January, the Boston office of the Securities and Exchange Commission informed GE that it was opening an investigation into the way GE was hedging the interest rate risk on the massive amounts of commercial paper it issued.
GE’s practice of issuing short-term commercial paper to raise cash and lending it long-term at higher interest rates caused the source of funds and the subsequent loan to have mismatched durations. Commercial paper had to be repaid within nine months, but the resulting loan might last decades. Because of the mismatch in duration, the interest rate on the commercial paper could rise over time while the rate on the long-term loan was locked in. Changes in interest rates could squeeze GE profits, so it hedged that exposure by using derivatives. To avoid earnings volatility from the regular changes in value of those derivatives, the SEC allows companies to use specialized accounting for hedging. GE had fallen afoul of those rules and, according to the investigation, tried to cover it up to avoid taking a $200 million charge to its profits. KPMG auditors working at the company allegedly signed off on the inappropriate moves without approval from superiors in the national office.
August brought more heat as the SEC issued a formal order of investigation in the matter after spending months reviewing company documents and records. The potential charges were serious, especially in light of the suspicions that GE’s steady earnings were being carefully managed under the cover of its incomprehensible complexity. For some, the investigation was proof of misconduct that GE’s size and reputation allowed to be easily swept under the rug.
With the SEC investigation, the wolf was now inside the door. As investigators dug in to scrutinize GE’s accounting decisions, they didn’t have to limit their scope to the commercial paper hedging issue. Their mandate allowed them to reach back into the past to see if the company’s accounting over the years had been misleading. And the investigators were free to take their time doing it.
All GE could do was cooperate with information requests and answer questions. The investigative team soon found a slew of questionable practices that showed the scope of GE’s ability to stretch, manipulate, and ignore accounting practices that are required of all public companies for the protection of investors.
The investigators found that if GE decided to sell an asset to boost quarterly profits and couldn’t find a quick buyer, it sometimes called up someone close to home to buy the asset. Years earlier, in 2002 and 2003, GE had sold a number of diesel locomotives to banks, knowing that the banks would resell them months later. Six of these deals had been approved by internal auditors, even though GE maintained the risk related to owning the units and kept the engines running on GE property.
In a much bigger mess, investigators found fishy accounting on sales of jet engines and parts. GE had falsely boosted its profit margins on jet engine sales by combining low-margin engine sales with expected future sales of high-margin parts to come up with a higher “average” margin. It then used vague balance sheet entries so that the difference could be spread out over time.
GE’s own accountants had grown worried that the accounting wasn’t proper as far back as 1999, a finding confirmed by its auditors, and worried that fixing the books would result in taking a charge of $1 billion. Despite their concern, and without auditor objection, GE decided to continue accounting for the engines in the same way, while funding a write-off against the deferred balance so that it wouldn’t continue increasing. In layman’s terms, the company had set aside money to cover up the improprieties.
There was also a separate problem with accounting for engine parts: an internal GE business learned that it was paying higher prices to another division for parts than some external customers. To ensure that it used the lower price in its accounting, the company created a work-around. Because the parts were part of a customer service agreement (CSA), the related revenue was recognized using a method based on the incurred cost in relation to the length of the agreement. If the prices were adjusted down to the more competitive rate, the total calculated cost of meeting the obligations of the contract would fall and cause an instant boost to revenue and profit called a “cumulative catchup.” The move allowed GE to adjust for the newfound profitability of an existing contract, updating its value to reflect the asset’s true worth.
It isn’t hard to see why a business might want to do this, but a GE accountant shot down the idea with a stark reminder: it wasn’t possible to increase the earnings of the entire company based on an internal price change.
A little imagination yielded another solution. By transferring the engine parts at cost (rather than via an internal sale) to the CSA business, the contract’s profitability rose and triggered a contract accounting adjustment. The outcome was a large gain that offset the other accounting loss needed to eliminate the ongoing margin averaging in the engines business. The so-called catchup added about $1 billion to revenue and profit, thus offsetting an $844 million hit from removing the parts from the averaging scheme.
Naturally, this move wasn’t allowed under accounting rules. It wasn’t consistent with GE’s other accounting, and companies are prohibited from making such discretionary changes.
And the $156 million difference that resulted from the change? GE also appeared to break the rules on that. Instead of recognizing the gain, the company took a page from the methods allegedly used during the Welch years: it banked it, in order to offset later earnings shortfalls from the internal price change.
Immelt’s consistent declarations about the company’s astute risk management and the dependability of his own management sharply contrasted with what the SEC was uncovering. Even some inside the company saw a culture that didn’t match Immelt’s spin that Capital was superior than the banks with which it competed because it was imbued with the “magic of management” for which GE was known.
“Our financial services businesses are inherently more valuable than those of traditional banks or other financial services companies. Why? Because we have significant global origination in end-user markets that we understand better than others,” he wrote to investors around this time.
These kinds of reassurances would take Immelt only so far as the timbers of the entire US financial system began to creak. In mid-2008, the country’s largest mortgage lender, Countrywide Financial, had sold itself in a fire sale, shocking an already turbulent market. The Federal Reserve had slashed interest rates in the last months of 2007 and already cut them twice again in January 2008.
Capital had been a source of anxiety and worry for Jeff Immelt since his earliest days at the top of the company. He liked the people and loved the results they produced. He also enjoyed having the accompanying seat at the table with Wall Street power players. But in the end, Capital was always a problem. It was utterly complex and filled with risk, and its tentacles reached everywhere in the company. In addition, the broader market had lost its former patience for letting big industrial companies mess around in the risky business of finance.
Dabbling in financial services had virtually destroyed GE’s historical rival Westinghouse. In some GE Capital offices, there were framed articles about Westinghouse’s fall in the 1990s, a collapse linked to its overexposure to financial services and commercial real estate—along with a bad bet on its core business, the power generation market.
To achieve his visions for growth, Immelt felt that he had to optimize the GE portfolio for the long term. That vision would become his focus. Immelt’s trust in his own ability to see strategic opportunities years in the distance was matched only by his trust in GE’s operational rigor. His challenge was to set the company on the proper course to success and profit. The legendary management ethos baked into the DNA of the place would ensure that the right steps were taken to execute his plans. Jeff was the captain of the ship; his obligation was to stay at the helm, not get bogged down in the intricacies of the engine room.
This sort of gut-driven management style could be rationalized—or explained at the very least—to the industrial divisions. But many of Immelt’s grand visions fell flat at Capital, and that reception may have contributed to his distaste for that business. The marketing-based commercial strategy Immelt was imposing on GE’s industrial units didn’t really translate to financial services. And his optimism-driven management style, all pep talks and insistence that sheer determination to prevail could surmount any obstacle, didn’t go over well with a division that measured success and failure in fractions of a percentage point and whose analyses almost always turned on quantitative factors. Capital’s leaders knew what they were doing and understood the business, but they also faced enormous pressures, and certainly had many incentives, to make their targets at all costs.
Capital had a hard time trusting Immelt and his marketing push. Many felt that some of the declarations emerging from GE corporate headquarters reflected a fundamental lack of understanding of the financial service industry. To them, what worked in selling appliances wasn’t going to work at Capital.
How well did Immelt understand the complexities of GE Capital and how the gains it earned and the risks it took helped or hurt the rest of the company? The question is unanswerable. Immelt’s supporters scoffed at the notion that he failed to understand one of the most important profit drivers in the company. But some of his closest advisers soon began to question, in private, how well Immelt understood basic financial concepts. Their attempts to explain to the boss what they feared he didn’t fully grasp were proving futile. He always waved away their doubts.
How much of Immelt’s response to these efforts could be explained away as self-deprecation, especially on the part of an executive for whom it was a first instinct in a room full of strangers? Company flacks liked to remind newspaper reporters and others who challenged his decisions that Immelt had studied applied mathematics at Dartmouth. He’d gone on to the nation’s preeminent business school—not exactly a friendly place if you don’t like math. But Immelt also sometimes joked that his math skills were so poor that he couldn’t help his daughter with her homework.
Then again, these were answers to the wrong question. Finance is numbers-driven, but it isn’t just about math.
Jack Welch had often expressed amazement at Capital and the comparable ease with which it made a dollar by loaning one, rather than by designing and building and selling a machine. Even in his best-selling memoir, Welch had confessed to a lack of understanding of the intricacies of the business, even as he pushed to expand the finance business and its importance to the company at large. Welch had even commissioned his staff to write a booklet of finance basics; he wanted to make sure he didn’t get it wrong.
Some of his colleagues suspected that Immelt’s background in sales and the industrial units had left him with a fuzzy grasp of the financial basics. His positions in those businesses had been meaningful, and he had been responsible for their finances. But GE’s matrix management structure had assigned others to be the crucial arbiters on some of the most complex financial decisions in which he had been involved.
Financial services was different from anything Immelt had worked with up close. Making money from money seemed shockingly simple to him at first, as it had to Welch, but the balance sheets were treacherously complex, and deep risks lurked there and were not always easily spotted in the quarterly profits and losses. It was reasonable to think that Immelt didn’t know much about how the greasy gears of Capital worked. In reality, it isn’t clear that many people anywhere understood those complexities.
Still, pinning down how well the company’s leader understood its crucial lending unit was impossible even for some of those who were closest to him. Some of Immelt’s critics acknowledge that he was sharper on finance than they expected. But another who worked closely with him for years said that Immelt struggled with basic concepts—the difference between secured and unsecured debt, for instance, which was fundamental to a lending operation like GE Capital.
No one communicated any of these doubts, however, outside of GE. As 2007 drew to a close, Immelt brandished his usual bright outlook when talking about GE Capital. Immelt’s optimism was a fortress.
“Our financial services businesses should do well in a year like 2008,” he wrote. “There could be $300 billion of assets available at high returns. We plan to seize opportunities in the current turmoil and position our financial services businesses for years of profitable growth.”