Track the companies that matter to you. It's FREE! Click one of these fan favorites to get started: Apple; Google; Ford.



GE Fits Buffett's Bill

The juxtaposition, though completely circumstantial, is delicious. A day after Warren Buffett released his annual letter to Berkshire Hathaway(NYSE: BRK.A) shareholders, General Electric(NYSE: GE) proves one of his points.

Buffett, a long-term finger-wagger at the pitiful state of corporate ethics and conduct, had this suggestion for investors: "Beware of companies displaying weak accounting. If a company['s] ... pension assumptions are fanciful, watch out. When managements take the low road in aspects that are visible, it is likely that they are following a similar path behind the scenes."

While I wouldn't call GE a "severe accounting abuser," its labyrinthine business leaves plenty of room for earnings management, something the company has done unabashedly in the past. This past year, GE CEO Jeffrey Immelt intimated that those demanding increased disclosure of operations should be careful what they wish for, as the company could provide mountains of information.

That didn't happen, fortunately. But GE did seem to conform to the letter of the accounting law, and not the spirit, by burying in a footnote that its pension fund lost more than $5 billion in 2002, even though it reported more than $800 million from pension fund gains. Under pension accounting treatment, companies are supposed to report actuarial returns, not actual ones. Dollars above the fully funded pension amount can be counted toward ordinary earnings. GE's expected returns were estimated to be 8.5%, so the fact that the fund actually lost more than 11% didn't matter.

(And people say stock options accounting would "distort" GAAP earnings. Pffffft.)

This multibillion-dollar actual loss equals 30% of GE's reported earnings for the year. Moreover, the company will have to adjust all of its actuarial tables to recalculate for the loss in principal. GE's 500,000 pensioners need not worry about their retirement; the company reports that it's still overfunded.

Yes, but overfunded how? Companies are allowed to set their own expected returns for pension assets. GE recently dropped its expected return from 9.5% to 8.5% per year. Now, 8.5% returns may not seem like a lot, but remember, it's not like these funds can just roll the dice in the stock market -- they are widely diversified among stocks, bonds, and government paper.

GE's useful investment avenues are minimized by the fact that doubling a $100 million investment means next to nothing; 8.5% is a fairly high hurdle, and 9.5% is nuts. In the past, Buffett has suggested that a 6.5% maximum return is safest. But companies have incentive to maintain higher expected rates because the "overfund" can be counted as earnings. In such an environment, "safety" becomes tertiary. Change the percent just a little bit, and the overfunded portion rises dramatically. It's the law of compounding turned sinister.

GE handled this disclosure properly. But did they handle it well? Certainly not. It's nowhere in the annual report's "Management's Discussion and Analysis" section. Yes, GE is extraordinarily complicated, but a $5 billion loss of capital seems to warrant at least a mention, doesn't it?

Starting this year, the SEC has asked companies to provide improved disclosure of actual pension performance after a 2002 study of more than 500 annual reports showed a general deficiency and a poor reflection of financial reality. GE's discussion of its pension returns falls far below this goal.

Buffett's remarks may have been targeting much less reputable companies, but he appears to have hit General Electric right between the eyes.

Bill Mann owns shares of Berkshire Hathaway.

Read/Post Comments (0) | Recommend This Article (0)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Compare Brokers

Fool Disclosure

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1151062, ~/Articles/ArticleHandler.aspx, 5/27/2017 12:40:56 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Today's Market

updated 15 hours ago Sponsored by:
Change down DOW 21080.3 -2.7 0.0%
Change up S&P 500 2415.8 0.8 0.0%
Change up NASD 6210.2 4.9 0.1%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

5/26/2017 4:00 PM
GE $27.45 Down -0.04 -0.15%
General Electric CAPS Rating: ****