Shares of General Electric (NYSE: GE) dropped 11% on August 15 after the company was accused of accounting fraud. Specifically, GE was alleged to have intentionally misrepresented losses from a long-term care (LTC) business that it acquired many years ago.

Typically, accusations of this sort are viewed with suspicion by Wall Street. That’s because they are almost always propagated by greedy short sellers with ulterior motives.

In this case, the accuser is Harry Markopolos, who became famous for uncovering the Bernie Madoff scandal. Although Markopolos also is working with a hedge fund that has a big short position in GE, he has the street cred to get everyone’s attention.

Markopolos not only posted his accusation online. He also made public a 175-page report detailing the numbers supporting his claim.

According to Markopolos, the magnitude of GE’s fraud amounts to $38 billion, making it “bigger than Enron and WorldCom combined.” That’s significant because both Enron and WorldCom subsequently went out of business and key executives went to jail after the frauds were uncovered.

For that reason, investors are justified in avoiding GE until the company has an opportunity to formally respond to Markopolos’ accusations. If he is correct, GE eventually could be forced into bankruptcy.

However, there is a critical difference between GE and the other two companies. Accordingly, GE’s current price drop could prove to be a trading opportunity for investors willing to roll the dice.

Closing the GAAP

The accounting frauds perpetrated by Enron and WorldCom were committed by scheming executives with the intent to deceive the public to enrich themselves. They engaged in illegal and immoral behavior before, during, and after the fraudulent transactions were executed.

Not so in the case of GE. Markopolos is alleging that the company discovered after the fact that it had miscalculated the cost of servicing the LTC policies and has engaged in deceptive accounting practices to hide these errors from shareholders ever since.

There is nothing illegal or immoral about paying too much for an asset that later proves to be worth less than originally expected. That happens all the time and is usually remedied by a write-off that reduces shareholders’ equity.

That is relatively easy to do when the asset in question is a tangible item with a known market value. However, it is considerably more difficult to calculate the value of an intangible asset with an unknown market value.

In the specific case of LTC policies, the great unknown is how long the insurer will have to pay out on them. Medical breakthroughs have extended life expectancies to levels not imagined even 10 years ago.

If Markopolos is correct, then somewhere along the line GE decided to obfuscate the higher cost of this business rather than recognize it. That may be true. But unlike Enron and WorldCom, there is sufficient gray area here to give GE the benefit of the doubt.

What this may boil down to is an esoteric legal argument over actuarial assumptions and GAAP (generally accepted accounting principles). Markopolos may not agree with the manner in which GE has chosen to account for its LTC business. However, that does not necessarily make it illegal or immoral.

Trading Opportunity

This type of disagreement is fertile ground for options traders. On the day this news broke, the implied volatility of GE put and call options expiring in December ran as high as 185%.

For example, a call option with a $3 strike price could be bought for $5 while GE was trading at $7.90. That means the breakeven price of $8 was only 10 cents above what it would cost to buy the stock outright.

If you believe GE will survive this ordeal and get back to $10 within the next four months, the call option allows you to amplify that gain by more than 50% (the $2 gain on the $5 option premium amounts to a 40% profit, while a $2 upward movement on an $8 stock is a 25% profit).

Conversely, if you think GE is heading to $6 by this December, then buying the put option with an $8 strike price for $1 would nearly triple your rate of return (the $1 gain on the $1 option premium amounts to a 100% profit, while a $2 downward movement on an $8 stock sold short is a 33% profit).

The disparity between those two options trades suggests to me that the market does not view Markopolos’ allegations as an existential threat to GE in the near term. Of course, that could quickly change if GE fails to articulate a credible defense for its actions.

In the weeks and months to come, shares of GE will be hypersensitive to any news seeming to prove one side of the argument or the other. The underlying options will be even more volatile, creating short-term trading opportunities for gutsy speculators.

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