Ethics Problem: During the 1990s, General Electric put together a long string of

Question

Ethics Problem: During the 1990s, General Electric put together a long string of consecutive quarters in which the firm managed to meet or beat the earnings forecasts of Wall Street stock analysts. Some skeptics wondered if GE “managed” earnings to meet Wall Street’s expectations, meaning that GE used accounting gimmicks to conceal the true volatility in its business. How do you think GE’s long run of meeting or beating earnings forecasts affected its Cost of Capital? If investors learn that GE’s performance was achieved largely through accounting gimmicks, how do you think they would respond?

Explanation / Answer

Part A)

Financial statements are prepared by any company to meet the information needs (indicating the profitability) of the investors and capital providers. A highly risky company would attract lesser investors who in turn will require higher rates of return on their investments resulting in higher cost of capital for the company. On the other hand, a company enjoying good profits and credibility will be able to attract investments at a lower cost of capital because of lesser risk.

In the given case, GE managed to meet or beat the earnings forecasts which indicated a sound financial position for the company during the relevant quarters. As a result, investors must have viewed the company as less risky and must have provided the capital at lower cost. In other words, these forecasts would have resulted in lower cost of capital for the company.

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Part B)

If investors would have known about the actual methodologies that were used to show sound financial position, they would have disregarded the company and preferred not to make the investments in such a company. Violation of reporting practices or use of unfair methods to present a better financial position is unethical. In such a case, most of the existing investors would have withdrawn their investments. Moreover, it would have been difficult for GE to raise more money from the market resulting in an increase in the cost of capital for the company.

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