General Electric: No Evidence Of Fraud In The Company's Power Segment

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About: General Electric Company (GE)
by: Daniel Jones
Summary

In his report alleging widespread fraud at General Electric, Harry Markopolos took aim at the company's Power segment.

A mixture in the adoption of accounting principles, combined with an oversight issue on the part of Markopolos clears this up.

While fraud is always a possibility, there appears to be no evidence of it in the firm's Power segment.

Questions still swirl regarding allegations of fraud against industrial giant General Electric (GE). Among many other claims made in his famous, or perhaps infamous, short report wherein he likens the business to Enron and Worldcom combined, Harry Markopolos focuses some of his efforts on questioning the accounting treatment of the firm’s fallen angel, its massive Power segment. Though this is not exactly the core of the short report against General Electric, it does strike at the heart of the same line of business that has been the poster child for the company’s decline. Any investor or analyst seeking to understand the conglomerate would be right to place a good deal of emphasis on what happens within this segment, but Markopolos’ bombastic allegations when it comes to Power can be readily cleared up by making a simple observation of how the firm’s financials work.

Disclosure & Focus

In two prior articles, here and here, I addressed the most damaging claims made by Markopolos. In each of those claims, particularly around the LTC (long-term care) policies on the company’s books, there is some ambiguity that could be open to interpretation. However, the nature and extent of General Electric’s overall disclosures covering those topics leads me to believe that, rather than engaging in fraud on those matters, the company is being truthful with investors while participating in aggressive accounting. On some of the more nuanced topics there, a court might rule the opposite way, but I would place that probability as being in the minority, but that is neither here nor there. When it comes to Power, which is the focus of this piece, there is little room for ambiguity.

A look at Power

Over the past several years, the Power segment at General Electric has been one of the conglomerate’s largest and, up until recently, most profitable. A mix of declining industry demand and a bad acquisition (Alstom) made by management has led to years of pain at the segment and, according to the company’s current leadership, this pain will persist for some time still.

*Taken from Markopolos Report

In his short report wherein he alleges General Electric has been engaged in fraud, Markopolos looks briefly at the firm’s Power segment and, as you can see in the image above, focuses on some changing revenue and profit numbers from the 2016 through 2018 fiscal years. The largest disparity here covers the fact that, in its 2016 annual report, General Electric stated that revenue associated with its Power segment came out to $26.827 billion, but in its 2017 annual report it increased this figure considerably to $36.795 billion. This is one of multiple “shenanigans” that Markopolos refers to in his short report that he believes is proof of the company’s inappropriate behavior.

*Taken from General Electric

Such a move does, at first glance, look suspicious. However, all it takes is a little look at General Electric’s 2016 and 2017 annual reports to find the reason behind the change. In the image above, you can see a reference to the fact that, in the third quarter of 2017, the company moved its Energy Connections business from its Energy Connections and Lighting segment to its Power segment and renamed Energy Connections and Lighting to just Lighting. To see the impact here, we need only look at the table I made below.

*Created by Author

As you can see, from the initial 2016 annual report to the 2016 data provided in the 2017 annual report, the revenue of only two segments changed: Power and what became Lighting. Lighting’s sales for 2016 were reduced from $15.133 billion to $4.823 billion. This change of $10.31 billion is remarkably close to the $9.968 billion increase in sales reported for the Power segment as a result of the change. The disparity, an amount of just $342 million, is tougher to pin, but the bottom line here is that General Electric is providing historical financials in a manner so that they are comparable with prior years to the greatest extent possible.

The fact that Markopolos, a man who should know more than accounting than I do (I have a Masters in Accountancy with a concentration in financial reporting and attestation, but he has a CPA and is a CFE (Certified Fraud Examiner)), missed something so glaringly simple is not confidence-inspiring. Other changes have occurred as well, such as when it came to profits. In the table below, you can see the $0.1 billion disparity that Markopolos specified, reflected in the same transition of the Energy Connections business moving to Power.

*Created by Author

Moving on into 2017, the picture does become much more convoluted, with every segment reporting some decrease in revenues compared to the prior year’s release. This should come as no surprise to investors though, as General Electric has been undergoing significant restructuring and the divestiture of different businesses, some of which may not be large enough to even warrant a disclosure, and any sort of M&A activity is subject to purchase price allocation adjustments that, because they aren’t material, investors may not have access to. Excluding M&A activities, the decrease in revenue from 2017 to 2018 was only $210 million, which is hardly material and might be attributable more to retrospective earnings adjustments caused by the adoption of new accounting standards in 2018.

Speaking of changes, this brings us to a big complaint by Markopolos: that General Electric changes its financial statement reporting formats every few years with the aim of continuing to defraud investors and make their financials harder to track. I have my own problems with the conglomerate’s reporting methods (not from a legal perspective but from a transparency one), but to make such a bold claim without concrete evidence is dangerous. With a company as large as General Electric, changes to its many, diversified segments, especially during periods of M&A, should be expected, and while it could be done with the intent to commit fraud, jumping to that conclusion appears trigger-happy.

Takeaway

Based on the data provided, it seems clear that while Markopolos is right to point out that reporting format changes and management’s adjustment of various financial data for prior years are definite red flags when it comes to fraud, he made some simple oversight issues regarding Power. Between retrospective adjustments that now reflect new accounting standards, plus the change in segment composition seen recently, the changes made to Power and the company as a whole should not be looked at in such a negative light like they have.

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.