Introduction To Special Purpose Entities

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This Statement also provides guidance about whether a transferor has retained effective control over assets transferred to qualifying SPEs through removal-of-accounts provisions, liquidation provisions, or other arrangements. Before discussing the evolution of authoritative guidance for SPEs, we examine the broader issue of off-balance-sheet financing, the context within which the guidance has been developed. SPEs are just one of the vehicles that companies use to structure financing that avoids recognizing assets and liabilities on their financial statements.

The cash received from selling this investment vehicle was used by Enron to make “energy-related investments” but structuring the deal through an SPE allowed Enron to keep any reduction in shareholder’s equity off the balance sheet. Within 24 hours, speculation abounded that Enron bookkeeping would have no choice but to file for bankruptcy. Enron was estimated to have about $23 billion in liabilities from both debt outstanding and guaranteed loans. Citigroup and JP Morgan Chase in particular appeared to have significant amounts to lose with Enron’s bankruptcy.

In the latter there is a single axis around which the reporting entity coalesces – generally this will be the central controlling authority like a company board. It even sold dubious assets special purpose entity enron to its SPEs at inflated prices to produce bogus income. And it had almost 900 off-balance-sheet partnerships located in international tax havens, a fact that mystifies most experts.

special purpose entity enron

(Well Over a Year Before the Extensive Use of SPEs by Enron Became Headline News.) So what does this information tell us? It tells us that average Americans today, more than ever before, are willing to place their hard earned savings and their trust in the U.S. capital markets. They are willing to do so because those markets provide them with greater returns and liquidity than any other markets in the world and because they have confidence in the integrity of those markets. That confidence is derived from a financial reporting and disclosure system that has no peer. A system built by those who have served the public proudly at organizations such as the Financial Accounting Standards Board (“FASB”) and its predecessors, the stock exchanges, the auditing firms and the Securities and Exchange Commission (“SEC” or “Commission”). Morgan, William O. Douglas, Joseph Kennedy, and in our profession, names like Spacek, Haskins, Touche, Andersen, and Montgomery.

From the investor perspective, isolating the assets/cash flows serves to insulate the transaction from the potential bankruptcy of the originator as well as its overall credit risk profile. In doing so, it allows the investor to take on the isolated risk in the transaction in question rather than the wider populations of risk that are probably inherent in direct equity or debt investments of the originator. In addition, if the obligations of the cash flow-backed SPV are to be more highly rated than the direct obligations of the originator, complete isolation from the risk profile of the originator will be requisite. Until recently, many people in the accounting profession, including accounting educators, never heard of SPEs. Some who heard of these esoteric financing vehicles knew little about how they operated or the accounting standards that guide the accounting and financial reporting by companies who sponsor SPEs. Reports in the popular press that preceded Enron’s Chapter 11 filing in December 2001 introduced many accountants for the first time to the topic of SPEs and sent many CPAs scrambling to understand the generally accepted accounting principles dealing with these entities.

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After initial measurement, the assets, liabilities, and noncontrolling interests of a consolidated variable interest entity will be accounted for as if the entity were consolidated based on voting interests. The accounting rules regarding SPEs (SFAS 125, SFAS 140, and EITF 84-30, 90-15, and 96-21) were designed for companies engaged in the sale and lease back of physical assets. Accordingly, for Enron to avoid consolidating the financials of these SPEs, each SPE had to meet three criteria. Second, the general partner of the SPE has to have control of the SPE in such a way that it does not act on behalf of the sponsor (e.g., Enron). Lastly, the SPE must possess the lion’s share of the risks and rewards of ownership. As long as these criteria were met, Enron did not have to consolidate an SPE on its financial statements. Enron typically used the Equity Method of accounting for SPE’s meaning they simply added Enron’s proportional share in the earnings of each SPE in a single line item on its income statement without disclosing corresponding balance sheet, cash flow and other considerations.

It is essentially using the receivable as a security to peddle to the market, hence the moniker — the securitization of assets. A company can create a “mini-me” of its own, a special-purpose entity, and apply for cheap financing. It’s actually one of the main reasons corporations use special-purpose entities. So wouldn’t it be great if you could create a little mini-me and have him apply for the loan?

First, at least some of them involved Enron selling assets to the SPE and recording significant profits. That’s apparently why income statements had to be restated when the SPE’s were consolidated by Enron. Normally, SPE’s are a form of off-balance sheet financing but they don’t cause differences in reported income. A second difference in Enron’s case involves the guarantees that Enron made to issue its own stock if things didn’t go well for the SPE’s. I don’t really understand these particulars yet, but they certainly seem to be quite different than the more typical types of SPE’s mentioned earlier.

Enron’s executives violated the condition that the SPE was not supposed to act on behalf of the sponsor (i.e., Enron) because of the obvious conflict of interest. Moreover, these SPEs were not left alone to bear the success or failure of their investments. In fact, Enron’s finance team made numerous amendments to many of the agreements with their SPEs over time so as to shield Enron Corporation from losses accrued. Enron executives also violated the third criterion for non-consolidation regarding the risks and rewards of ownership. Clearly, the risks and rewards of ownership were not fully transferred to these SPE’s.

What services is Mr. Woodford calling for to investigate the inappropriate payments and accounting practices by Olympus? Specifically name the type of engagement for which Mr. Woodford thinks that Olympus should contract with outside accountants. The Tokyo Stock Exchange said it’s considering moving the shares in Olympus, the world’s biggest maker of endoscopes, to a watchlist for possible delisting. Takayama pledged to continue with the investigation into the losses, which he said were probably inherited by Kikukawa. “Institutional investors will stay away from Japan’s market until they confirm this is an isolated case,” said Koichi Kurose, chief economist in Tokyo at Resona Bank Ltd. Some “investors probably think that if there’s one cockroach, there may be 10 more,” he said. Japanese and U.S. regulators are probing allegations by former chief executive officer Michael C. Woodford that more than $1.5 billion was siphoned through offshore funds.

  • This combination meant that Enron’s stock went down as the value of these other assets went down.
  • Under current practice, two enterprises generally have been included in consolidated financial statements because one enterprise controls the other through voting interests.
  • This ruse was used several times to fool analysts about the progress of different areas of Enron to help improve the stock price.
  • The main idea is that while most corporations and partnerships have broad leeway to engage in any legally permissible business activity, SPEs will have limitations built into their incorporation documents that specifically limit the scope of allowed activities.
  • But KKR says the unit is owned by Capstone’s management, not KKR, and isn’t an affiliate, so it hasn’t shared the firm’s fees with investors.

Many of the SPEs used for securitization purposes are “qualifying” special-purpose entities that often issue securities rated by credit-rating agencies. Thus, Skilling and his team became determined to boost the stock price of Enron in hopes that their management incentives would translate in bigger compensation for them. Following the Enron scandal, companies are now much warier of agency issues and the misalignment of corporate objectives versus management incentives. Unconsolidated affiliates what are retained earnings used to generate significant profits -Why? A company could be using SPEs to move poorly-performing assets off its financial statements to avoid dilution of reported earnings or to generate gains. With respect to the behavioral dimensions of the Enron scandal, there are many factors at work. Because there was a kernel of truth to Enron’s financial innovation — and because the complete financial profile of Enron was disguised from the public — the market became swept up in Enron euphoria.

How Do Firms Use Spes?

Enron disclosed reams of information, including an eight-page Management’s Discussion & Analysis and 16 pages of footnotes in its 2000 annual report. But other sophisticated analysts and fund managers have said that, although they were confused, they bought and lost money. Joe Beradino is the CEO of the auditing firm that audited Enron for years prior to and during the sudden meltdown of Enron in late 2001. Mr. Beradino tended to blame SPEs for much of the problems in Enron’s audited financial statements.

special purpose entity enron

ARB 51 requires that an enterprise’s consolidated financial statements include subsidiaries in which the enterprise has a controlling financial interest. That requirement usually has been applied to subsidiaries in which an enterprise has a majority voting interest, but in many circumstances the enterprise’s consolidated financial statements do not include variable interest entities with which it has similar relationships. The voting interest approach is not effective in identifying controlling financial interests in entities that are not controllable through voting interests or in which the equity investors do not bear the residual economic risks. ARB 51 requires that an enterprise’s consolidated financial statements include subsidiaries in which the enterprise has a controlling financial interest. That requirement usually has been applied to subsidiaries in which an enterprise has a majority voting interest, but in many circumstances the enterprise’s consolidated financial statements do not include variable interest entities with which it has similar relationships. To combat the issue of SPEs encountered in Enron’s case, a new accounting rule came out in 2003 to outline tests that a company must perform to determine if it had variable interest and was the primary beneficiary of an entity. If both tests were positive, such an entity was required to be consolidated into company’s financial statements.

Some SPVs share the same balance sheet with the parent company and have their equity, assets, and liabilities recorded on the parent’s balance sheet. However, off-balance-sheet SPVs are more common, with this strategy, a parent company can effectively lower its risks, and have enhanced liability management and more flexible financial structure.

What Is A Special

If such an obligation exists, then the sponsor recognizes it as a liability, and the sponsor records the R&D costs incurred by the SPE as an expense. To avoid recognizing the liability and expense, the sponsor must demonstrate that the financial risks involved with the R&D activities are transferred from the sponsor to the outside parties.

special purpose entity enron

The Powers Report suggests, however, that tacit guarantees were made to Fastow and partners. First, the existence of any such guarantees would require that the sponsor consolidate the SPEs in question under EITF and D-14. Furthermore, SFAS 107 defines such guarantees as financial instruments or liabilities, requiring either disclosure of the fair value of such guarantees or, if estimation of fair value is not practicable, descriptive information pertinent to estimating the financial instrument’s value. SFAS 125 requires transfers of such financial instruments to be initially recognized at fair value. In its December 31, 2000, notes to the financial statements, Enron disclosed many details about the nature of its transactions with LJM2 (dubbed “the Related Party”) and Andrew Fastow (referred to only as “a senior officer of Enron”). Many of these details, however, contradict subsequently revealed information.

The Most Typical Holding In A Special Purpose Vehicle

Discover practical risk management tips, insight on important case law and be the first to receive important news regarding IRMI products and events. Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author’s employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser. The main idea is that while most corporations and partnerships have broad leeway to engage in any legally permissible business activity, SPEs will have limitations built into their incorporation documents that specifically limit the scope of allowed activities.

Enron Scandal Summary Of Its Use And Abuse Of Special Purpose Entities Spe

Such a transfer of financial assets, if it qualifies as a sale or purchase, lowers the sponsor’s cost of capital, because it isolates the assets from the risk of sponsor bankruptcy. Loan underwriters and credit-rating agencies often require business entities involved in synthetic leasing and commercial mortgage-backed securities to be SPEs. Furthermore, the transferor generally derives a tax advantage because the SPE is a pass-through entity that does not pay its own taxes. The benefits of lower financing costs, lower taxes, and off–balance sheet financing can often outweigh the cost of establishing and maintaining the SPE. In short, the SPE was designed, in part, to minimize risk, but also to bypass accounting treatments that would otherwise increase leverage and decrease earnings.

Enron Aside, Special Purpose Vehicles Spvs Are Legal, Innovative And Widely Used

Skilling stated in an interview that the numbers provided to analysts were “black box” numbers that were difficult to pin down due to the wholesale nature of Enron, but assured the press that they could be trusted. At Enron’s peak in mid-2001, the company’s shares were trading at an all-time high of $90.75. Then, as the scandal was uncovered, the shares plummeted over several months to an all-time low of $0.26 in November 2001. Another QuickBooks energy firm would be more visible to financial and energy regulators. In turning to the ethics of these transactions, several Enron employees were secretly offered financial interests in LJM1 by Fastow through Southampton SPE. These employees accepted the opportunity in clear violation of the company’s Code of Conduct policy. It’s not quite clear, but participation in these SPE’s suggest a combination of behavioral processes at work.

A Special-Purpose Vehicle Company is a limited company which is set up for the sole purpose of purchasing property and property management for buy-to-let activities. Enron was an admired company prior to 2000 because at that time it surfaced as a frontrunner in the deregulated energy market, making it possible to sell energy at higher prices, thus significantly increasing its revenue.

Despite Enron’s best efforts to conceal their losses, by late 2000, skepticism started mounting. The dotcom bubble had fallen from its peak, and company fundamentals were being questioned. By the end, Enron owed $38 billion, of which only $13 billion was on its balance sheet. Fastow, who saw himself as a savior of the company, inappropriately participated in these deals himself, providing the 3% independent capital for the SPE . In Fastow’s view, these were “just commissions,” and Enron owed him for saving the day. Enronomics was a fraudulent accounting technique used by criminal executives at long-dead Enron Inc. that involved hiding losses in subsidiary books.

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