Heimer Progress 1

Special Purpose Entities (SPEs), also known as off-balance sheet arrangements, 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. 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.

Prior to the crash of Enron, accounting standards dealing with SPEs were unable to provide consistent results. The principle behind SPE accounting stated “the usual condition for a controlling financial interest is ownership of a majority voting interest.” 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.

During the 1990’s, Enron 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. 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. Because it would allow Enron to appear attractive and profitable to investors and analysts, Enron chose to use SPEs.

New accounting standards for SPEs were implemented after Enron. As FIN 46R explains 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 or in which the equity investors do not bear the residual economic risks. The FASB’s objective is not to restrict the use of VIEs but to improve financial reporting of them.

More information to follow.

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