Heimer Draft 1

Special Purpose Entities: A Before and After Enron Look with an Emphasis on Consolidation

Special Purpose Entities (SPEs), also known as off-balance sheet arrangements, have become a household business term since the days of Enron. Due to the case of Enron, many changes were made to accounting standards for SPEs. SPEs bring up very interesting topics for discussion as their use was a major factor in the collapse of the Fortune 500 company, causing thousands of people to lose their jobs and retirement funds. SPEs date back to the 1970’s when many companies engaged in securitization, meaning a pool of financial assets is transferred into securities. The idea behind this was to isolate financial risk and provide less-expensive financing. SPEs do not take part in business transactions other than the ones for which they are created and are backed by the sponsor (the party that created the SPE). Therefore, they are able to raise funds at lower interest rates than those the original party could obtain. Over the years circumstances have changed with SPEs, as discovered from Enron, and change was required.

It is important to first discuss what exactly SPEs were including in their treatment before the Enron case. I will follow that with a discussion on the Enron situation that made SPEs a household name. I will also discuss how the rules for consolidation of SPEs have changed since the Enron case. Finally, I want to discuss some situations still arising today with SPEs from the same type of situation as Enron. I would like to close with some thoughts on the future of SPEs and accounting in general. It is important to note that Enron is not the only company that has encountered these issues, as will be discussed later. A study by Coallier disclosed an interesting viewpoint on SPEs. The study said SPEs remind us of the old game of “Hot Potato.” With SPEs, the company that winds up consolidating the entity’s debt holds the hot potato. As we will learn, Enron wound up holding about 4,000 hot potatoes.

What are Special Purpose Entities?
SPEs are used as a way to provide less expensive financing. Off-balance sheet entities are created by a specific party to carry out a specific purpose, activity or series of transactions. This is done by transferring assets to another party. There is no purpose for the entities created except to perform the transactions for which they were created. There are also a number of legal forms the entities can take. SPEs can be limited partnerships, limited liability companies, trusts, or corporations. SPEs share many characteristics, including: often being thinly capitalized; typically having no independent management or employees; administrative functions are often performed by a trustee who serves as an intermediary between the SPE and its creators, and if the SPE holds assets, one of these parties usually services them. There are three main reasons that SPEs are formed: (1) to finance assets or services and keep debt associated off the balance sheet of the sponsor party; (2) to transform assets into liquid securities (securitization); and (3) to engage in tax-free exchanges (Soroosh and Ciesielki, 2004). To help better understand SPEs, imagine you have a great deal of debt, which creates a problem getting decent rates on loans. You could create another you, a separate entity, which would have no debt and you could transfer assets to the “other you”. Theoretically, you would be able to use the “other you” to obtain good interest rates for loans because the other you is debt-free.

There are many different types of SPEs that need to be discussed to help better understand the purpose of the SPE. Synthetic leases are a popular form. What happens is that the sponsor sets up a shell company for buying and financing assets for specific use by the sponsor. The SPE owns the asset, charges rent to the sponsor, and pays off the loan. They allow the treatment of leases as operating leases and allow the sponsor to claim ownership. There are take-or-pay contracts, in which a buyer agrees to pay amounts at certain periodic times for products or services. There are throughput contracts, in which one party agrees to pay for the transportation or processing of a product. Another reason to form an SPE, as mentioned above, is securitization, where a pool of assets is transformed into securities. In order to work successfully, the company must structure the transaction to have no effective control over assets being removed from its balance sheet.

There are a number of advantages to using SPEs, obviously the reason why companies choose to use them. One advantage is allowing the ability to lower risk by transferring risks and rewards to a non-consolidated third party. SPEs can also create tax advantages. Typically, they are not taxed at the entity level, if a pass-through entity. Typically, the size of SPE transactions is quite large, and the tax savings usually outweigh any costs associated with the upkeep of the SPE. Lastly, SPEs can many times reduce credit risk and possibly lower financing costs. SPEs are very powerful finance tools. The banking community and investment community have greatly benefited from SPEs. Since SPEs normally have been “off-balance sheet”, bankruptcy-remote and very private in nature, their purposes can be both legitimate and illegitimate. Even when used correctly, there can be a margin of ethical question involved.

SPEs Before Enron
Prior to Enron making SPEs a common business term with their misuses, there were very relaxed and unclear guidelines for accounting for SPEs. Understanding how SPEs were accounted for previous to Enron will help us to better understand how Enron misused SPEs as well as better understand the need and reason for the new changes in accounting for SPEs since the Enron case. Prior to the crash of Enron, accounting standards dealing with SPEs were unable to provide consistent results with SPE reporting. This was caused by standards having been incomplete and in fragments. The principle behind SPE accounting stated “the usual condition for a controlling financial interest is ownership of a majority voting interest” (ARB 51).

The problem arose with the creation of sophisticated SPEs where sponsors maintained control without majority voting power. This allowed these companies to avoid consolidating these entities, even though in substance they had control, but this so-called control did not meet the definition given (Soroosh and Ciesielki, 2004). Also, there was the 3% rule, which allowed for no consolidation by EITF Issue 90-15. The 3% rule stated that the sponsor did not have to consolidate the assets and liabilities as long as the equity interest of a third-party owner was at least 3% of the SPEs total capitalization (2004). In 1996 the FASB released SFAS 125 in an attempt to try and deal with transactions of SPEs. However, it was quickly realized that there were many flaws in the statement and it needed to be revised. SFAS 140 became the end result (2004).

Enron and Their creative Use of SPEs
The report of investigation by the Special Investigation Committee provided great information on what was occurring at Enron. During the 1990’s, Enron, a Fortune 500 energy company, grew very rapidly and moved into various areas of business in which it had not previously been involved. The vast amount of growth required a great deal of capital investment, and the problem was that these investments were not expected to realize significant earnings until well into the future. Having to invest large amounts of capital and not realizing material revenues until well into the future would place a heavy burden on Enron’s balance sheet. The debt level of Enron was already at high levels. The vast amounts of debt already incurred, added to the amounts needed for future investments, would affect Enron’s credit rating, which is vital in the energy industry.

One solution to their problem was to find outside investors who would enter into deals that would help Enron retain risks it could mange effectively. Joint investments would be structured as entities, separate from Enron. This would allow the entities to borrow at acceptable rates from outside lenders. The question arises as to the treatment of these entities. These entities are subject to accounting rules that determine if the SPEs should be consolidated or treated as “off-balance sheet”. This is where the rules prior to Enron, which were discussed above, come into play. Because it would allow Enron to appear attractive and profitable to investors and analysts, Enron chose to use SPEs. This allowed them to not have to consolidate these entities and allowed them to appear a more stable company than they actually were.

The question that now must be answered is how was Enron able to not consolidate these SPEs they were using to put all this debt on their book? As we know from above discussion, consolidation can be avoided if first, an independent owner of the SPE has a substantive capital investment, dealing with the 3% of total capital rule. Secondly, the independent owner must exercise control over the SPE. Enron worked to structure their arrangements in order to circumvent these rules and allow them to not have to consolidate their SPEs. Over the years, using these SPEs, Enron would sell assets that were losing money to these entities. Enron would record these sales as revenue. The rules being fragmented and having holes in them allowed Enron to sneak around the rules and treat theses SPEs as they saw best for them. Enron offloaded debt onto the Raptors’, the Chewcos’ and the LJMs’. Due to certain guarantees given by Enron, the third parties that were involved in Enron’s special arrangements never actually assumed any of the risk that was claimed and allowed Enron to not consolidate their SPEs. Another problem was that these SPEs relied on Enron managers to lead and also relied on Enron stock for capital. When these actions were becoming clear, outside auditors forced Enron to treat the nearly 4,000 unconsolidated SPEs they had created over the years as a part of Enron. This resulted in the company taking a billion dollar hit against earnings. Most know what happened from there, Enron went bankrupt, executives were charged by the SEC and many people lost their jobs and retirement funds. Besides what happened to Enron, accounting was changed forever. Sarbanes-Oxley came into effect and SPEs became a household name. Obviously, the way Enron used SPEs was far more sophisticated than previous statements had intended them to be used. SPEs were supposed to be a legitimate way for companies to help relieve debt pressure, but companies like Enron found ways to abuse and destroy the good idea behind SPEs.

Was Enron the Only One?
It is very important to note that even though most of us only know of the Enron case when it comes to SPEs, they were just the major one caught in the public eye. This problem that happened in the early 2000’s with SPEs was not just a one-time incident caused by Enron. Research shows many other cases of similar abuse; and to help show the magnitude of this problem, these situations must be noted. At the time the Enron situation became public knowledge, there were also other companies involved in similar dealings including Banco Ambrosiano, BCCI, AIG and Parmalat, to name a few. Of those named, Enron was by far the biggest company and had the greatest problems with SPEs; so as the media sometimes does, they focused specifically on one situation, Enron. Banks also took a big hit due to the changes made to the way SPEs are to be accounted for, which will be discussed later.

Banking companies were forced to move billions of dollars of assets back to balance sheet with the advent of the new reporting rules. An article by Boraks and Rieker discussed Bank One shifting 38 billion dollars. Citigroup Inc. reported five billion dollars transferred back onto books and many more that had no official dollar amounts but were expecting billions to be moved in the near future. Major changes in accounting principles that so greatly affects the banking industry could possibly have a huge impact on the economy. Situations like this could affect mortgage rates and lending rates, which we all know have a huge impact on the U.S. economy. Banks have to be careful with future transactions and know how to handle the massive change to their balance sheets. Transparency was the major problem. The financial statements did not reflect the actual stability of the company.

What about today?
Even still today it is possible to find cases of Enron-style misuse of SPEs. This brings up the question; How long will this continue? It has been over seven years since Enron came public; and if we are still seeing companies being charged by the SEC, this could be a continuing problem. The issue as I see it deals with how SPEs were accounted for by these Enron-type companies. As they were made invisible to analysts and investors, it would be very hard for anyone, other than management and perhaps auditors, to know that these SPEs hiding all this debt even exist. Inevitably, this could be a situation that continually will come into play over the next many years. It could possibly take years for anyone to discover companies are doing what Enron did. Some may wonder where the proof is of this happening today. After all, we never hear stories anymore of Enron-type situations.

A CNN article from March 2008 discusses Biovail and charges placed on them by the SEC for the misuse of SPEs, along with some other broken laws. Biovail has agreed to settle with the SEC for ten million dollars (CNN, 2008). This case is not nearly the size of the Enron case, as Biovail was not hiding debt anywhere near the billions like Enron. This did, however, come public after Enron. A 2006 study by Taub discusses a similar situation with PNC Financial Services Group. They were charged with keeping nearly 762 million dollars off the balance sheet. This allowed for a major overstatement of earning. These cases show us that even though it has been a number of years since Enron, we still see cases coming public of the SEC charging companies with misuse of SPEs. It is important to remember this is not a one-time issue related specifically to only Enron.

Accounting for and Consolidating SPEs after Enron
The issue brought forth by Enron was simply when are SPEs to be consolidated on the balance sheet of the originating institution? A study by Macaluso and Wilkinson helps explain the new critical concepts to the consolidation determination: First, the primary beneficiary; and second, the variable interest. The primary beneficiary is the one with the controlling interest in an SPE. Note this is established by means other than voting interest, which is the normal consolidation rule. This “other” controlling interest is where we get the variable interest. The main variable interest in an entity is equity, which is defined as residual economic interest, which is variable interest by nature. The idea of variable interest instead of equity used because with certain entities, legal equity is irrelevant from the view of risks and rewards (FIN 46R). This is the issue that arose from Enron. What Enron used would now be called variable interest entities.

FIN 46R brings up deals with variable interest entities (VIEs). These entities have one or more these following characteristics: The equity investment at risk is not sufficient to permit the entity to finance its activities without help provided by any parties, including equity holders. Also, the equity investors lack the direct ability to make decisions through voting rights, the obligation to absorb the expected losses of the entity or the right to receive the expected residual returns of the entity. Finally, The equity investors have voting rights that are not proportionate to their economic interests, and the activities are on behalf of an investor with a disproportionately small interest (FASB, 2003).

As FIN 46R explains, from Enron-type situations, the FASB learned that the voting interest approach is not effective in identifying controlling financial interests in entities that are not controlled through voting interests, the way Enron structured their SPEs, or in which the equity investors do not bear the residual economic risks, again like Enron. The FASB’s objective is not to restrict the use of VIEs but to improve financial reporting of them. Consolidation is required of the primary beneficiaries if the entities do not effectively disperse risks among the parties involved. The primary beneficiary is the party that absorbs a majority of losses and returns of the VIE (FASB, 2003).

The Macaluso and Wilkinson study states steps for determining whether consolidation is required for a given SPE. First, it must be determined if the SPE falls under a special exception. There are a number of exceptions, but for the scope of this paper we will just note that there are these exceptions. Next, if it does not meet a special exception, the equity investment must be determined and deemed to be sufficient. Third, a determination must be made whether the SPE is a Financial SPE (FSPE) that can be treated differently. Finally, if the previous steps do not apply, assess whether there is a controlling financial interest through variable interests. If this is the case and the entity is the primary beneficiary, then it must consolidate the SPE.

To help determine sufficiency, the interpretation increases the 3% threshold to 10%. Again, as before, I should note there are some exceptions to the 10% rule, which for the scope of this paper will not be discussed in detail. For consolidation, it is important to discuss some of the accounting principles relevant to these SPEs. Assets, liabilities and noncontrollling interests generally will be initially measured at their fair values, except those transferred to the VIE by the primary beneficiary, which will be carried as if never transferred. Goodwill is recognized only if the VIE is a business as defined. The reporting entity will report an extraordinary loss for the amount that would be goodwill. After the initial measurement assets are to be accounted for as if consolidation was based on voting interests. An entity that holds a significant variable interest in a VIE but is not the primary beneficiary is required to make disclosures about the nature, purpose, size and activities of the entity. Also, the exposure to loss and nature of involvement must be disclosed. The primary beneficiary must disclose the nature, purpose, size and activities involved, the carry amount and classification of consolidated assets which are collateral for the VIEs obligations, and finally, lack of recourse by creditors of consolidated VIEs to the general credit of the primary beneficiary (FASB, 2003).

From what Enron has taught us, this interpretation is intended to help with more consistent application of consolidation principles and policies for VIEs, a new term after the Enron debacle. It is believed this can help with the transparency of financial reporting, which is constantly an issue in the accounting world today. The FASB continually reviews the conditions imposed on SPEs. They have regular meetings on SPEs to work to ensure all issues are resolved.

Concluding Remarks
I believe it is very difficult to predict what lies ahead in the world of SPEs. The effects on SPEs by the “Enrons” of the world have left them a household name synonymous with deception. The fact is SPEs can serve legitimate purposes, but the way rules were created did not sufficiently govern proper consolidation. Enron and others were able to avoid consolidation of SPEs that clearly should have been consolidated. Although new rules certainly help to prevent a future Enron from happening, there is no guarantee. As discussed above, there are still cases coming public of misuse of SPEs by companies. The problem, as I see it, is SPEs have been kept hidden in these Enron-type situations, and perhaps there are companies out there still hiding their misused SPEs in order to avoid an Enron-type situation. These cases discussed, such as Biovail and PNC, came public after Enron, so this could possibly continue for the next five or ten years. Also, if all these companies were able to figure out ways to avoid consolidation with previous standards, who is to say they will not be able to come up with ways to get around the new consolidation rules with FIN 46R?

A study by Mcallister made a very strong argument. The study discusses transparency reporting in accounting and financial reporting. It also discusses a fallacy in the assumption that being in compliance with generally accepted accounting principles (GAAP) is equal to transparency reporting. It uses the example of Enron and how the company’s accounting of special purpose entities as being GAAP-compliant, but as we are well aware, they were nowhere near being transparent. The study goes on to discuss the need for management and auditors to realize and understand GAAP does not always mean transparency. Improvements toward an equivalent with GAAP and transparency will allow for easier access to accurate information, better reporting, and reduce the number of litigations that so frequently occur.

I think this study makes a great point. Who is to say that the exact same situations are not occurring in not only the area of SPEs even still today but also in many other areas of accounting? As companies, transactions and arrangements become more complex, there will always be that one unethical person who searches for the easy way out, the deceptive practice in order to increase his/her own profit or make him/her appear a better leader. Perfect transparency with GAAP compliance is almost an unattainable idea, as there will always be ways to circumvent rules and hide unfavorable information.

Bibliography

Financial Accounting Standards Board. "Financial Accounting Series." Financial Accounting Foundation December 2003.

Boyd, Roddy. "Biovail Hubris Exposed." 20 March 2008. CNN Money. 15 April 2009. http://money.cnn.com/2008/05/19/news/companies/boyd_biovail.fortune/index.htm.

Soroosh, J., Ciesielski, J.,. "Accounting for Special Purpose Entities Revised: FASB Interpretation No. 46, Consolidation of Variable Interest Entities." CPA Journal (2004): 30-37.

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