Special Purpose Entities
...985 merger of Houston Natural Gas and InterNorth. In 1986, Kenneth Lay became the firm’s top executive. During the 1990s, Enron grew rapidly. Andrew Fastow, Enron’s CFO, helped create a complex financial structure for the new Enron. Enron changed its business from a natural gas company into one of the world’s largest energy traders. It generated funds by entering into extremely volatile, risky, and expensive hedging transactions. Enron’s Demise The first major deception was that Enron’s executives’ apparently used SPEs to deceive shareholders and to enrich themselves. Enron used about 500 SPEs and thousands of other questionable partnerships in order to structure transactions to achieve off-balance sheet treatment of assets and liabilities. Enron executives often held large personal interest in these partnerships and make massive personal gains in such transactions. It eventually became apparent to investors that Enron was using off-balance sheet partnerships that hid billions of dollars of liabilities. The three main SPEs Enron created were; Chewco, JEDI, and LJM Cayman. Many entities, like Enron, used SPEs because as long as long as at least 3% of capital comes from outsiders, an SPE can be left off the consolidated financial statement of the parent company (Enron). Enron was cooking the books to make its shares financially more viable, while creating little or no real shareholder and creditor value. The Unraveling In a November 8-K filing with the SEC, Enron disclosed its intent to restate net income by $569 million for the years ended December 31, 1997-2000 and the quarters ended March 31 and June 30, 2001. Enron disclosed various income statement and balance sheet adjustments, as the three SPEs should have been consolidated in the financial statements pursuant to GAAP. Enron later filed its 10-Q for the quarter ended September 30, 2001, updating earlier disclosures, and revealed that a $690 million note payable (related to one SPE) had been accelerated due to a downgraded in Enron’s debt rating. Enron also announced that additional debt amounts would be accelerated if its debt rating fell below investment grade. This indeed occurred, hence Enron’s bankruptcy filing. How to Account for Special Purpose Entities Accounting for SPEs involves a two-step approach. The first is the identification of the SPE sponsor. The second and more complicated step is deciding when an SPE should be included in the sponsor’s consolidated financial statements. Consolidation results in the sponsor recognizing SPE assets and obligations, and eliminating the effects of any intercompany transactions. Thus, this eliminated one of the key advantages of creating the SPE. Two years after Enron Corp. collapsed; rule makers are continuing to wrestle with standards for what used to be called special purpose entities. Nonconsolidation of SPEs There are three basic rules for nonconsolidation of an SPE which require that the independent equity investor: • Continuously invest at least 3% of the SPEs assets • Exercise control of and assume risks of the SPE and • Like all transactions, provide real (potential) economic benefits to Enron As long as these specific qualifications are met, the assets and corresponding debt and equity of the SPE can achieve off-balance sheet treatment with respect to the sponsor’s financial statements. FASB has recently proposed new standards to ensure that unconsolidated SPEs are truly independent of their sponsoring entity. Sharing the Blame Critics say FASB has failed to write accounting standards on a number of key issues, such as off-balance sheet entities. However, this is only partly true. A review of the available record and history of accounting fro SPEs, reminds one that the SEC, not FASB, wrote the accounting rules in this area. Emerging Issues Task Force (EITF) Topic D-14, Transactions Involving Special Purpose Entities (‘1990), outlined the SEC’s requirements on the accounting for these entities, and said, “The SEC staff is considering the issuance of a Staff Accounting Bulletin (SAB) setting forth guidelines on the accounting for transactions involving SPEs and until such time would consider transactions on a case-by-case basis. The SEC Observer emphasized that the SEC staff views the issue of SPEs to be primarily a consolidated issue.” Clearly, the SEC staff essentially wrote the SPE rules in Topic D-14, and over the past dozen years the SEC reviewed and policed the subseque...