Worse Than You Think – Part 1

Congress surprised me a little while back, when they decided not to bail out the ‘Big 3’ automakers, who were hoping for just about fifty billion tax dollars (25 billion already requested and they wanted to add another 25 billion just because). Given the way the press is spinning the 700 billion set aside to address the financial markets, I was worried that the Congress would just toss off another 50 billion without looking into the matter. But instead, Congress displayed an unexpected but welcome prudence, demanding that Detroit demonstrate better responsibility. I wondered just what was missing, so I started looking into the financial health of these companies. Boy howdy, these guys are in really bad shape, and more, throwing money at them won’t do a lick to change their crash course.

Before I go into these companies, I need to explain why extra money won’t help. There are a number of factors which can cause a company to fail. In the case of the financial markets, most of the banks made mistakes but in general are fundamentally sound in design and practice, so that infusions of cash and credit are sufficient to get the company back into good working order, and there is high confidence that the money spent will be repaid in full. Other causes exist for business problems which may or may not be addressed effectively with cash, but there are certain conditions which signal severe risk of failure. The three major US automakers all exhibit such indications of imminent failure, and these conditions cannot be ameliorated by simply increasing cash flow for a short time.

The first case to consider is General Motors, which was created in 1908. GM’s company profile states that the company has 266,000 employees in 35 countries, and in 2007 sold 9.37 million cars and trucks. Looking at the highlights from the 2007 Annual Report, I see that GM took in over 178 billion dollars in revenue (or around nineteen thousand dollars per car or truck sold) from sales and just under 3 billion dollars from finance and insurance services. Despite this, the company’s adjusted net income is a reported loss of 23 million dollars for 2007. But that’s not the part that worries me. The loss before a reported “change in accounting principle” for 2007 was 38.7 billion dollars, meaning these geniuses spent an average of over twenty-three thousand per car or truck manufactured, so that they lost four thousand dollars on each and every car or truck they made that year.

That line about changing the accounting principle bothered me; that’s not normal GAAP and if it happened more than once in a short span it’s a very bad sign about a company’s reporting. So I went to the next report and had a look at 2006 ...

And saw the same notation, changing a two billion dollar loss in 2006 to a reported two billion dollar profit. In 2006, GM made just about 9.2 million cars and trucks and sold them for just over 207 billion dollars, or $22,585 each. But that year it cost GM about $22,800 for each car or truck they made, so while it was not as bad as 2007, the problem was there as well – it just got worse in 2007. We know why; sales for low-mpg cars and trucks fell through the floor as gas prices shot up, while the cost of making the things still climbed. And that change in accounting principle bothered me, so I checked out the footnote they stuck on it for an explanation; it read: “A reconciliation of adjusted amounts in these Financial Highlights and in the Chairman’s Letter to Stockholders to amounts determined in accordance with accounting principles generally accepted in the United States may be found at www.gm.com/company/investor_information/, Earnings Releases, Financial Highlights”. If that does not make sense to you, you are reading it correctly, because there is no direct link to that explanation – you have to chase it down, so I did. Buried in the letter to stockholders and features, in rather fine print, GM noted that in 2007, “GM’s total adjusted net loss in 2007, excluding special items, was $23 million, reflecting a $1.1 billion loss attributed to our 49 percent stake in GMAC. While GMAC’s traditional auto financing business performed well, those results were more than offset by massive losses in GMAC’s mortgage businesses. Including special items, GM reported a loss of $38.7 billion, or $68.45 per diluted share in 2007. This loss is almost entirely attributable to the non-cash $38.3 billion special charge in the third quarter related to a non-cash valuation allowance against deferred tax assets. The valuation allowance has no impact on cash, and does not reflect a change in the company’s view of its long-term financial outlook.”

By itself that might fly. But remember, we also saw this the year before, so I looked at the 2006 version, and found this:

“Following a review of deferred income taxes and our accounting for derivatives under Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities, we restated our balance sheet, stockholders’ equity and reported net income in our financial statements from 2002 through the third quarter of 2006. These adjustments had no material impact on cash flow for any of the restated periods.”

In plain English, this is what most people would call a lie. GM took a two-billion dollar loss, and spun the numbers to call it a two-billion dollar profit. They did this by changing the way they addressed their mortgage losses. I expect they thought this would be a one-time thing, but the fact it is, this change materially changed GM’s representation of their financial condition, which violates GAAP. While GM claims to have followed SFAS 133 with regard to its derivative accounting, the FASB clearly states in the summary of that Statement, “an entity that elects to apply hedge accounting is required to establish at the inception of the hedge the method it will use for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. Those methods must be consistent with the entity's approach to managing risk.” [emphasis mine]

This means there are two problems with GM’s claim – first, they did not establish this accounting at the inception of the hedging action, but after the fact, and two – this change materially changed the reported financial condition of the company, which violates the FASB’s Statement of Concepts No. 5. This ought to have provoked an SEC investigation, and I am guessing only GM’s size prevented that from happening prior to now. Certainly the action violates GAAP as I know it.

So, two accounting principle changes in as many years, both of which alter the corporation’s reported financial condition. Feeling iffy yet? Well, let’s go back to 2005 and see if they were still playing Hinky Financial Reporting then as well. And yep, there it is again. A 10.4 billion dollar loss is adjusted to show only a 3.4 billion dollar loss, because of “Hughes Electronics and Special Items", again with a footnote telling us to go hunt down the details.

Before I get to that detail, I want you to note what the executives at GM were saying after the 2005 year, before they started playing games with their 2006 and 2007 numbers: “We also have a renewed commitment to excellence and transparency in our financial reporting. The recent discovery of prior-year accounting errors has been extremely disappointing and embarrassing to all of us. Credibility is paramount, for GM as a company and for me personally. While I will not offer excuses, I do apologize on behalf of our management team, and assure you that we will strive to deserve your trust. The fact is that errors were made, and we can’t change that. What we have done is disclose our mistakes and work as diligently as we can to fix them.”

It’s, ahem, pretty obvious that GM never fixed its problems, nor did they stop covering up their poor management. In 2005, once again GM changed its numbers to make a loss look prettier, changing a 10.4 billion dollar loss into a 3.4 billion dollar loss by fooling with the books. The detail in the 2005 Annual Report advises that for 2005, GM adjusted its numbers on the basis of a stock split of a former subsidiary, Hughes Electronics: “In December 2003, GM split off Hughes by distributing Hughes common stock to the holders of GM Class H common stock in exchange for all the outstanding shares of GM Class H common stock. Simultaneously, GM sold its 19.8% retained economic interest in Hughes to The News Corporation Ltd. (News Corporation) in exchange for cash and News Corporation Preferred American Depositary Shares. As of the completion of these transactions on December 22, 2003, the results of operations, cash flows, and the assets and liabilities of Hughes were classified as discontinued operations for all periods through such date presented in GM’s consolidated financial statements.”

Note that GM’s decision to accept shares from News Corporation PADS was a voluntary act by GM, and so it is difficult to argue that the corporation should be allowed to separate those losses from its financial reporting; it’s not as if the losses really go away if you do not admit them.

I could go on. Number fudging by GM occurred in its 2004 and 2003 reports, and five straight years of changing the way you do your financial reporting should be a big red flag to any auditor, especially since there were at least three major causes for the changes. There are numerous indicators of significant financial instability and poor management (a new CEO or CFO might be surprised by bad news, but when it keeps happening it’s a sign that the guy in the seat is a bad driver), and if GM had been an ordinary company, we’d have seen a government investigation long before now.

To be continued in parts 2 and 3