- 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.
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.
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.
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.
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.
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.
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.
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