Heimer Final

Special Purpose Entities: A Before and After FIN 46 Look

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. The idea behind SPEs is to isolate financial risk and provide less-expensive financing. Therefore, they are able to obtain funds at lower interest rates than the original party could. Starting with Enron, accounting scandals have revealed that some companies took advantage of the consolidated rules for SPEs, based on majority vote, to avoid reporting assets and liabilities and to defer losses (Powers, 2002).

It is important to first discuss what exactly SPEs are, including their treatment before FASB Interpretation No. 46 (FIN 46) on sponsors. I will follow with a discussion on the Enron scandal that made SPEs a household name. I will also discuss how SPEs have changed in scope since the implication of FIN 46 and examine the economic consequences of FIN 46. Finally, I want to conclude with some situations still arising today with SPEs and my thoughts on the future use of SPEs and accounting.

What are Special Purpose Entities?
Special Purpose Entities are distinct legal entities with a limited life created to carry out a narrowly defined pre-specified activity for a “sponsor” company (Coallier, 2002). SPEs can serve business purposes such as facilitating securitization, leasing, hedging, research and development, reinsurance, and other arrangements. 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; and often administrative functions are performed by a trustee who serves as an intermediary between the SPE and its sponsor. 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 Ciesielski, 2004).

The three reason why SPEs are formed coincide with their advantages. Obviously SPEs have many advantages since companies choose to use them. One advantage of SPEs is sponsors can borrow money at a much lower rate than they otherwise get from issuing debt, especially when their default risk is high. Another advantage is SPEs allow the sponsors to remove receivable from their balance sheets and avoid recognizing debt incurred in the securitization. Finally, the sponsors are bankruptcy remote in the sense that they lose their investment in the SPE if the SPE fails (Zhang, 2008).

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. A popular type of SPEs are operating leases. What happens during an operating lease is the sponsor sets up a distinct legal entity for buying and financing assets for a specific use. The SPE owns the assets and uses them as collateral to finance the purchase. The sponsor company is able to keep the assets off their balance sheet only if it qualifies as an operating lease. 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 popular type of SPEs is securitization. With securitization a pool of assets is transformed into securities. In order to work successfully, the sponsor must structure the transaction so they have no effective control over the assets being removed from their balance sheet. Exhibit 1 from the Soroosh and Ciesielski study shows the results of 66 public companies and the amount of transactions in certain types of SPEs from 1999 to 2001 (Soroosh and Ciesielski, 2004).



SPEs Pre-FIN 46
Prior to Enron making SPEs a common business term with their misuses, SPEs had very relaxed and unclear accounting guidelines. Understanding how SPEs were accounted for previous to FIN 46 helps us better understand how they were misused and helps us realize the need for new accounting standards. Prior to FIN 46, the primary measure for consolidation was majority voting interest. In other words, if a company owned more than 50% of the voting interest of another company, it was required to consolidate that company. Companies could easily avoid the 50% rule but owning exactly 50% of the SPE while still maintaining effective control (Zhang, 2008). This allowed sponsors to avoid consolidating these entities, even though they maintained control.

Enron and Their Creative Use of SPEs
During the 1990’s, Enron, a Fortune 500 energy company, grew very rapidly and moved into several areas of business in which they had not previously been involved. Incurring this amount of growth required a great deal of capital investment, however 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 for many years would place a heavy burden on Enron’s balance sheet. With their amount of debt already at high levels, adding more debt 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 risk it could manage effectively. Joint investments were structured as legal entities, separate from Enron. This allowed the entities to borrow at acceptable rates from outside lenders. The question arose as to the treatment of these entities. These entities were subject to accounting rules that determined if the SPEs should be consolidated or treated as off-balance sheet. Here is where the rules prior to FIN 46, which were discussed above, come into play. Off-balance sheet transactions allowed Enron to appear more attractive, profitable, and stable to investors and analysts than they actually were.

Investors and analysts alike still wonder how Enron was able to avoid consolidation of SPEs for so long without being noticed. Enron worked hard to structure their arrangements around the accounting standards, which allowed them to avoid consolidating their SPEs. Over the years, Enron sold assets to SPE that were losing money and recorded these sales as revenue. The third parties involved in Enron’s special arrangements never actually assumed any of the risk that they claimed. Eventually, Enron's actions became clear to outside auditors. The auditors forced Enron to treat the nearly 4,000 unconsolidated SPEs they created over the years as a part of Enron. Consolidation resulted in Enron 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 the collapse of Enron, accounting standards have changed significantly. The FASB Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46) and Sarbanes-Oxley came into effect. Obviously, the way Enron used SPEs was far more complicated than I have previously explained, but it gives a clear picture how companies structure arrangements around standards to impove earnings. SPEs were created as 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.

SPEs Post-FIN 46
In January 2003, the FASB introduced FIN 46, which requires companies to base consolidation not only on votes, but also on economic control. If no party has more than 50% ownership, the party that bears the majority of the risk or enjoys the majority of the rewards of the SPE needs to consolidate the SPE (Zhang, 2008).

Several economic consequences arose after FIN 46 was introduced causing many companies to take immediate action. Companies consolidating SPEs expected to see increases in their assets and liabilities, which in turn decreases their rate of return and increases their leverage ratio. In response, companies using SPEs to meet financial commitments were reducing their SPE use and reducing their on-the-book leverage to help cushion to impact of FIN 46. In June 2003, Credit Suisse First Boston (CSFB) estimated that about $800 billion off-balance sheet liabilities of Fortune 500 companies would be recognized onto their balance sheets. Exhibit 2 from Zhang's study shows the companies with possible SPE liabilities to equity greater than 50% estimated in 2003 (Zhang, 2008). Furthermore, the managements efficiency which is measured by rate of return is expected to decrease due to an increase in recognized assets.



Companies consolidating SPEs also expected to see a rise in their perceived risk, which in turn increases their cost of debt and equity. The increased risk is accredited to investors leaning their company now has more risk from previously undisclosed off-balance sheet activity, therefore, increasing in the cost of debt. When FIN 46 was introduced it definitely increased the financial leverage and perceived default risk of companies engaged in SPE, causing the debt of the companies the increase. Exhibit 3 from the Zhang study provides the cumulative average default rates of corporate bonds by Standard & Poor’s rating at issue from 1981 to 2005 (Zhang, 2008). The exhibit shows the higher the default risk, the worse the credit rating.



What about today?
Even today it is possible to find cases of Enron-style misuse of SPEs. It has been over seven years since Enron's scandal became public and we are still seeing companies being charged by the SEC. This will likely be a continuing problem. The issue as I see it deals with how SPEs were accounted for by Fortune 500 companies. As SPEs were made invisible to investors and analysts, it would be very hard for anyone, other than management and perhaps auditors, to know realize companies are hiding debt. It could possibly take years for anyone to discover companies are hiding their debt. After all, Enron's situation rarely occurs.

I happened to run across a CNN article (2008) that discussed the Biovail Hubris scandal. Biovail Hubris is a Canadian drug company. Biovail was charged by the SEC for the misuse of SPEs, conspiracy, US kickbacks and some other broken laws. Biovail agreed to settle with the SEC for ten million dollars. This case is not nearly the size of the Enron scandal, as Biovail was not hiding debt anywhere near the billions like Enron. Their case did, however, come public after Enron. This case proves that even though it has been a number of years since Enron, we still see cases where the SEC charges companies with the misuse of SPEs. It is important to remember that Enron was not a one-time issue, there are many more.

Concluding Remarks
I believe it is very difficult to predict what lies ahead in the world of SPEs. The effects on SPEs by the “Enron’s” of the world have left them a household name synonymous with deception. The fact is SPEs can serve legitimate purposes, but pre-FIN 46 rules did not sufficiently oversee proper consolidation. Enron and others were able to avoid consolidation of SPEs, which knowingly should have been consolidated. To account for SPEs consolidation, FASB introducted FIN 46. The goal of FIN 46 is to improve financial reporting and protect investors by enhancing the representational faithfulness of financial statements in circumstances where the risk and benefits of ownership are retained (Maines et al, 2003). Though research, I have found that FIN 46 is associated with a decline in the use of off-balance sheet arrangements and a effort by companies to decrease traditional debt and to increase equity (Zhang, 2008). Also, perceived default risk by bond rating agencies has significantly increased with the moving of off-balance sheet arrangements onto balance sheets. Although FIN 46 certainly helps to prevent a future Enron scandal from happening, there is no guarantee.

A study by John McAllister (2003) makes a very strong argument as to why there is no guarantee. The study discusses transparency reporting in accounting and financial reporting. It also discusses a misleading notion 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 SPEs 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 reporting will allow for easier access to accurate information, better reporting, and reduction the number of litigations that so frequently occur.

I think this study makes a great point. As companies, transactions and arrangements become more complex, there will always be that one unethical person who searches for the easy way out. They will search for a deceptive practice in order to increase their own profit or make them appear a better leader. Perfect transparency with GAAP compliance is almost an unattainable idea, as there will always be ways to avoid rules and hide unfavorable information.

Memorable Quote
Richard Green (1980) describes off-balance sheet arrangements as: “The basic drives of man are few: to get enough food, to find shelter and to keep debt off the balance sheet.”


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