GE: Don't Be Scared About The Revisions - Here Is What You Need To Know

Summary

• GE revealed revision to 2016 and 2017 EPS retrospectively.
• Initial reaction on the public forum indicates investors were treating the news as an incremental revelation, which is inaccurate.
• We break down the adjustment and educate investors of the root cause for the adjustment, which is the adoption of new accounting standards.

GE (NYSE:GE) announced earnings revision on Friday as part of their annual report filed with the SEC. There have been a few articles that reacted negatively to the announcement and argued that GE management has once again let investors down with the seemingly non-stop stream of negative news. While we have published a series of articles on GE's horrific record of dealmaking, we think readers deserve to know the facts and ought to evaluate management based on an objective view in mind.

The earnings revisions last week should really come as no surprise to investors as it was already previously disclosed by the management and was purely driven by adopting new accounting standards. No cash impact resulted and the earnings were revised for comparative purposes. GE does have many other problems as we detailed in our GE Series, however, this earnings revision is not one of them.

(CNN)

Nothing New Here

Some articles have incorrectly characterized the earnings revisions at GE as another ugly surprise. In fact, the earnings revision should not come as a surprise at all as the company has disclosed multiple times in its prior filings that a restatement of its prior earnings will be applied given the new accounting standards that it will adopt from January 1, 2018.

In GE's 2016 annual report, it already warned investors about the coming earnings revision as a result of adopting the ASU NO. 2014-09, Revenue From Contracts With Customers:

Companies can use either a full retrospective or modified retrospective method to adopt the standard. Under the full retrospective method, all periods presented will be updated upon adoption to conform to the new standard and a cumulative adjustment for effects on periods prior to 2016 will be recorded to retained earnings as of January 1, 2016. Under the modified retrospective approach, prior periods are not updated to be presented on an accounting basis that is consistent with 2018. Rather, a cumulative adjustment for effects of applying the new standard to periods prior to 2018 is recorded to retained earnings as of January 1, 2018. Because only 2018 revenues reflect application of the new standard, incremental disclosures are required to present the 2018 revenues under the prior standard.

GE then went ahead and stated that it has elected to apply the full retrospective method, believing it will be the most helpful to investors. Here is the full disclosure from GE that clearly warned investors about the revision for 2016 and 2017.

First and foremost, when we adopt the standard in 2018 we will provide investors with a consistent view of historical trends, as 2016 and 2017 will be on a basis consistent with 2018.

(GE Annual Report)

In its 2017 annual report filed last Friday, GE gave a more detailed disclosure of its estimated earnings revisions as a result of the new accounting standard.

We estimate that our 2016 and 2017 restated earnings per share will be lower by approximately $0.13 and $0.16 (before any impact from U.S. tax reform), respectively, driven primarily by the required changes in accounting for long-term product service arrangements

Earnings Revision Explained

So we have established that GE indeed provided disclosure and warning to investors that an earnings revision will be forthcoming. But should investors still be concerned with the significant impact on EPS? We think it is important for investors to understand the new accounting rules that are being applied across the U.S., which resulted in this earnings revision.

FASB And IASB

On May 28, 2014, The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) issued a converged standard on the recognition of revenue from contracts with customers. IASB is responsible for International Financial Reporting Standards (IFRS), a widely adopted accounting framework used by countries such as the EU countries, the U.K. and Canada. FASB is responsible for U.S. Generally Accepted Accounting Principles (U.S. GAAP), used predominantly by American corporations.

IASB and FASB claimed the standard will improve the financial reporting of revenue and improve comparability of the top line in financial statements globally. Currently, there are differences in the way how U.S. GAAP and IFRS accounting for revenue recognition, which has created problems and inefficiencies for investors comparing U.S. and international companies.

According to IAS, the new standard provides a single principles-based, five-step model to be applied to all contracts with customers. The five steps are:

• Identify the contract with a customer.
• Identify the performance obligations in the contract.
• Determine the transaction price.
• Allocate the transaction price to the performance obligations.
• Recognize revenue when (or as) the entity satisfies a performance obligation.

In terms of whether revenue should be recognized over time or at the point of sale, ASC 606-10-25-27 provided three criteria. If the entity meets one of the three criteria, then the entity should recognize revenue over time.

• The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.
• The entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced.
• The entity’s performance does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date.

(InnerVision)

Understanding The Earnings Adjustment

Investors should understand the nature of the earnings adjustments before freaking out. According to GE filing, the new standard requires companies to identify contractual performance obligations and determine whether revenue should be recognized at a point in time or over time - based on when control of goods and services transfer to a customer. As a result, GE expects two changes to their revenue recognition accounting:

• The timing of revenue recognition.

• Changes in classification between revenue and costs.

(Simplilearn)

GE also highlighted the segments that are expected to be impacted the most by the new accounting standards. In general, the biggest change for GE's accounting of revenue is to change from over time model where revenue is booked based on costs incurred plus an estimated margin, to a point in time model. The new revenue recognition standards also place emphasis on the transfer of control, rather than risk and rewards.

• Power and Aviation Service Agreements: For its long-term service agreements, GE will continue to use over time model includes costs incurred plus an estimated margin rate. The new rules will have changes in the scope of a customer contract and affect how modifications are accounted for existing contracts.
• Aviation Commercial Engines: GE stated that the financial presentation of its Aviation Commercial engines business will be significantly affected as they will be accounted for as of a point in time, representing a change from its current long-term contract accounting process. The biggest change here will be that instead of GE's existing accounting practice of "over time model," GE will have to account for each installed regime as a separate performance obligation, measured at its sale price and actual costs incurred. The impact will be significant for new product launches where the initial productions will cost significantly more than the later deliveries due to cost improvements.

Impact On GE Earnings

Investors should understand that the revisions are purely due to changes in the accounting treatment which does not have any impact on cash flow. The underlying economics of the contracts are intact and cash flows are still accounted the same way. What will happen is that GE expects 2018 and early years after adoption to have lower earnings due to high initial production costs for new projects. Over the course of the production lifecycle, GE expects earnings to increase as the contracts mature and production costs declines. Again, cash flow is unaffected and accounting treatment only affects earnings.

(Company website)

Other Accounting Woes?

Although we believe GE's earnings revisions were well-disclosed and should come as no surprise to the shareholders, there are a few other potential risks for 2018 from an earnings perspective.

The first risk is a potential impairment in the Power segment. As we detailed in "How Did GE Mess Up Its Alstom Power Acquisition?" the assets acquired as part of the deal have significantly underperformed relative to initial expectations. We think a risk of impairment in the segment is very likely as 2018 has not seen an uptick in demand for GE's products. The recent investigation of SEC over its revenue recognition could also prompt a downward revision of previous assumptions on the market prospect, which may result in a write-off.

(Bloomberg)

The second risk is another charge from the long-term care unit or other insurance units within GE Capital. As we wrote in "GE: A Full Break-Up Won't Happen" that another cash injection is not out of possibility given the delicate liquidity and balance sheet situations at GE Capital. The $6.2 billion charge was definitely the result of a mix of oversight and mistakes. We think as auditors become more vigilant and SEC is involved, there might be more catch-up in insurance reserves to be disclosed in the coming quarters.

Final Thoughts

After seeing the headline EPS impact, many investors and news outlets started claiming that GE has announced another accounting mistake and started questioning whether more negative news could be coming. We understand how easy it is for people to assume certain things once a pattern has been established, and GE certainly has itself to blame for making investors accustomed to treating every news as negative. However, as content providers, we thought investors still need to discern facts from headline-grabbing articles that could be misleading and interfere with your investment-making process.

Author's Note

We hope you found our article worthwhile. Consider "following us" to receive updates for future publications. Check out our recent Series on GE:

• Why GE Won't Break Itself Up
• GE: What Did Nelson Peltz And Trian Get Wrong?
• How Did GE Mess Up Its Baker Hughes Acquisition?
• Could GE Buy The Rest Of Baker Hughes?
• How Did GE Mess Up Its Alstom Power Acquisition?

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[rockjcp02]

CEO is working hard with his team but he must deliver a good Quarterly report before real money gets back in!

[Old Wizard]

He may be assuming that Transportation will be sold. If this is the case, one needs to know what cash will be received in the sale and what GE will do with it. By the way, I have written to the CEO of GE and have been contacted by their executive of shareholder relations to discuss answers to the questions I have been asking in the SA comments. It has always been a point of contention that the proceeds of asset sales in the past were advertised as being used to provide shareholder value in the form of dividends and share buy backs. I think we, shareholder’s, have not held management’s feet to the fire in that assets that were making money have been sold and proceeds put in acquisitions and initiatives that do not replace the revenue and profit that accompanied the assets sold.

[Mike Slattery]

To Old Wizard -

You post is excellent!!

It would be very desirable to have a simple, 1-page summary of the $200 Billion in asset sales in 2015 - 2017. We do know that $29 Billion of the proceeds went for buybacks. But everything else is a mystery - what were the total proceeds??.....just because an asset is "worth" something does not mean that is what the actual sale price (proceeds) was done at.

[James Coleman]

Hi OldWiz:

To my knowledge Tusa did not provide "color" to his "post-divestiture FCF"

In my view it is an exercise in futility to "drill down" with any rigor due to the reality we simply do NOT know what, when or for how much any parts, large or small, GE will divest.

Flannery has said a lot of contradictory things- re BH et al, and there's been news reports their "exploring" various sales but that's about it.

What I find most curious is WHY Tusa lowered his PT significanly not long after the 2/18 Barron's article.

What could caused him to go from $14 to $11 (a 20+% cut)??

To me he's putting his successful track record re GE stock on the line for no particular reason.

Unless he thot Inch was going to $12.50 or something.

Any thots?

Thank you.

[James Coleman]

Hello again OLdWiz:

I'm sure IR wouldn't say this, BUT why Flannery has announced $20 B in asset sales within 2 yrs. is because of their cash situation.

Div. and buybacks are the least of their concerns in my view.

I also believe that many SA posters do not fully appreciate the time-consuming and costly legal, accounting et al expenses involved.

And whether GE gets their "value" vs. what a "willing buyer" will pay
AND THE TERMS remains to be seen.

BTW if you talk to IR again, will you please ask them WHY the recent sale to a former GE employee was not explained in terms of HOW much, and on what terms?

Absent that VIP info, how do s/h know it was "an arms-length" transaction?

Answer- they don't.

So much for accountability and transparency Mr. CEO.

[AutoTech]

Impairment charges + asset sales (disposals) far below current valuations make this stock radioactive above $10 as Power will deliver even uglier things in 2018 than planned, expected.

Cash flow in 18 will maybe be $6B and quite a bit of that will pre-fund the pension problem.

No growth in cash for the foreseeable future --- u g l y.

[Mike Slattery]

To AutoTech -

"Cash flow in 2018 will maybe be $6B and quite a bit of that will pre-fund the pension problem."
......................... ......................... .........................

Really?? Really?? The following is to clarify -

Industrial "Adjusted Cash From Operating Activities" (CFOA) is estimated at $9 - $10 Billion in 2018.

Industrial "Free Cash Flow" (FCF) is estimated at $6 - $7 Billion in 2018.

The above data items are shown in the 10-K (page 103).

The above data items are NOT the source of pre-funding the pensions.

The pre-funding at $6 Billion will be "borrowed funds" ( = added debt) as stated by Flannery in his presentation (Nov 13th) (page 15).

[AutoTech]

We use free cash and that will come in around $6B in 2018. I said "quite a bit" of it will pre-fund the pension problem. They're borrowing because they're OUT OF CASH with a 95% payout ratio on the divy. Cash flow looks miserable for years to come as well.

Radioactive above $10 - JPM just said an $11 target (even that's high).

http://cnb.cx/2tI34ZX

[Mike Slattery]

To AutoTech -

Yes, you did say "quite a bit" of "Free Cash Flow" (FCF) will pre-fund the pension.

And you are WRONG. How many times do you have to be told that GE (Flannery) is borrowing the $6 Billion to pre-fund the pension??

And NONE of the Industrial FCF is being used for the pension. None!!

2) The payout ratio on the dividend is NOT 95% as you've posted. Using the range of Industrial FCF at $6 - $7 Billion in 2018, the dividend ($4.2 Billion annually) payout ratio is from 60% - 70%.

Check your data on how you got the wrong number.

[Adriano.chemin]

Things will get better in H2

[Old Wizard]

Good article. Your pointing to a possible impairment in power GE to overvaluing of Alstom assets might be seen as a surprise, but I doubt it. I believe that Immelt didn’t want to know the downside risks, because the community saw the Alstom acquisition as a real coup and Immelt’s bonus was highly dependent on this acquisition’s completion. The question remains: how much was Flannery’s bonus dependent on thus acquisition since he was credited with being instrumental in affecting it. Should a write-off occur, will it be characterized in GE financials as another one-time cost. How many times has one-time costs been part of the GE financials? Constant buying and selling of assets, discontinuance of operations, false starts like the solar panel manufacturing facility, hiring many software people then changing the strategy and laying off salesmen, etc all give rise to “one time” costs that because of their regularity might better be characterized as simply costs of doing business in the manner in which it has been conducted for much of the last 20 years. Haven’t heard whether or not this will change for the better under the new management regardless of what accounting standard is applied to revenue and income time recognition of equipment and maintenance contract sales.

[Cornerstone Investments]

Fair point. Most companies treat impairment as one-time which is appropriate in our view. Agree with the complexity of GE financials and the pervasive use of non-GAAP measure which makes it hard for investors to evaluate and understand the underlying business.

[James Coleman]

Old Wizard:

Very well said, as per usual. It's interesting to me the ALSTOM "deal" was at the time was heralded as essentially the deal of the century for GE as a GOOG search will reveal.

Cramer's comments then are particularly ironic now.

And Flannery was indeed intimately involed as a picture of him and Immelt in France to visit their Prez I posted shows.

*Perhaps* that's why GE's silence is defeaning re ALSTOM until the
eventual day of reckoning.

[winall]

Is Warren Buffett buying?

[Cornerstone Investments]

It's a rumour now, nothing announced yet

[xxypa]

It’s a clear buy at those levels
Short squeeze will do the rest
12 US-Dollar will not happen

[JDoe20]

“They adopted new accounting standards” . . . . . . . in other words they had none before?

[Cornerstone Investments]

the word "new" means there were "old" standards before.

[Rhmassing]

I have stopped reading all those write-ups on GE. The bottomline is it does have many problems, thanks to the previous CEO Inmmelt, which are being resolved gradually by the able new management, kind similar to the VRX situation. GE is not going to be bankrupt, but to reverse itself to its glorious past in two to three years by keeping its profitable core divisions and sell those unproductive divisions as the CEO is doing now openly and decisively. If one can expect its share to return conservatively to $35, those waiting for buying at $10 to $12 are meaningless exercises and more than likely unfulfilled expectation. When Warren Buffett even stated recently in CNBC he might be interested in buying GE, you know the bottom is here. I am long GE and IBM big time to compliment other high flyers, ADBE, LRCX, SHOP, SQ and WYNN, among others in my portfolio.

[jarco]

When it comes to GE, here’s what you need to know.
Where’s the door!

[adambryarton]

GE-Why bother?

[James Coleman]

Are you suggesting Flannery is going to take down Immelt and Welch for fraud?

[kdt34wqx]

It’s obvious that all three (and Sherin) are up their ears in corporate
malfeasance. GE shareholders should demand a “special prosecutor” to investigate these crimes. (If Shkreli went to prison, then Immelt et. al. shouldn’t be far behind.) If I had the resources, I’d do it myself.

[User 43269936]

They did not put a bounty on a lock of Clintons hair :)

[kdt34wqx]

Shkrei was charged (and convicted) with being "engaged in multiple schemes to ensnare investors through a web of lies and deceit". That's written all over Immelt and Welch.

[kdt34wqx]

GE managers call earnings restatements “changes in accounting standards”. The rest of the world calls it “fraud”. If Immelt has to answer in the courts for corporate governance fraud, then Welch is in trouble also. Welch knew all about the LTC insurance claims that GE recently disclosed. (Most of those contracts were written during Welch’s tenure.) Flannery has been counting beans at GE for thirty years. Flannery knows all about fraudulent accounting at GE. He was right there.

[ShineInvest81]

Waiting for it to drop like the Titanic then make hay.

[ckarabin]

The books are the books! The books tell you the value of the company and its income. It's always funny when a company revises down its income and then tells you "Don't worry, our income statement does not really explain what's happening at the company!"

What?!!!!!!!!! And so what that cash flow is unchanged! Income is what matters. Cash flow can be just recovery of investments, you still need to make a profit on those investments.

[JDoe20]

But cashflow is visible while “income” not so much.

[Mike Slattery]

To ckarabin -

"Don't worry, our income statement does not really explain what's happening at the company!"
......................... ......................... .........................

Would you provide the link or reference as to where it shows the above statement?? Was this really made by GE?? Or did you make it up and then to add "validity" to it, you conveniently put quotation marks "...." around it?? which of course, as you know, is not ethical and very misleading.

[falconetti aanthony]

ok ..a bit late. fact is GE's " aggressive accounting" made the company look stronger than it was..and that , in turn, manipulated the stock price...amazing how creative white collar crime descriptions can be " aggressive accounting" " mis spoken" ..I prefer deceptive accounting and lying to shareholders..but all are a well dressed, well educated lot, mt blanc pens, superior vocabulary..but when you hit them with the bright lights, they still scurry into hiding like roaches.

really, the damage is done.. GE has lost investors alot of money..and jack Welch and Jeff Ommlet have lost as well.. maybe both should be in jail.. but they are not.

the mop up continues...

[g.dimit]

These type things in Finance you might be called CREATIVE ACCOUNTING With other words
Manipulating the Numbers to look a lot better.

This type of Accounting make me Suspicious WHAT THE COMPANY TRY TO HIDE?

Possibly more Information should be come available the upcoming a few weeks

[Don Beynon]

Does the restatement really matter.. The cash to run the business has not changed. In my opinion this is not big deal.

[James Coleman]

Restatements negatively affect GE's financials, and makes them more vulnerable to a credit downgrade.

[Tetragrammaton]

ASC 606 was instituted for the very good reason that many companies were playing fast and loose with the way they accounted for partly-completed projects, with enormous exaggerations of the percentage of completion actually being achieved with specific projects, and thus being interpreted as "earned income" when there was little income, little earned and even less actually paid for.

A company which had been half-way honest in previous years would therefore see little need for a major recast of its prior-year accounts, to accommodate the new (and long-heralded) ASC 606 degree of honesty and accuracy. On the other hand, the more lascivious the previous exaggerations had been, the more the fudged numbers would need to be swallowed into a one-time charge against earnings.

I take the exact opposite view to that held by Cornerstone Investments. I think the massive recast of GE's accounts are a huge embarrassment to the company, to any remaining members of the prior BOD, as well as to the auditor. And of course it raises yet more questions about other shenanigans which may be revealed in GE's current and past accounts.

The size of the adjustments tells its own story, and investors need to recognize the (sad) significance of it for their investment in GE stock.

[James Coleman]

I completely agree with you as to WHY GE shoes to go this route.

Why they didn't choose other options available to them I believe is related
to the SEC probe, and their more than a decade long creative accounting practices.

GOOG this accounting change and you will find many more co's that chose an option other than GE.

[Just Some Guy]

Excellent analysis and article, thanks for the clarifications.