What's Right and What's Wrong With (SPEs), SPVs, and VIEs

Bob Jensen at Trinity University 

The Whitewing SPE is only one of the thousands of Special Purpose Entities set up by Enron CFO Andy Fastow with the assistance of its auditor, Andersen, and its law firm.  The SPE appears to be almost hopelessly complex to hide risk as well as hide the trail of the millions of dollars Andy Fastow was making in double dealing at Enron. 

As an educator, I find the following chart interesting because it illustrates the hopelessness of applying the new 2003 FASB Interpretation 46 (FIN 46) that requires tracing out the ultimate risks in deciding whether to consolidate SPEs (that are now called VIEs by the FASB).

The chart below appears as Appendix D beginning on Page 372 of the infamous Enron whistleblower's book.

Power Failure: The Inside Story of the Collapse of Enron, by Mimi Swartz, Sherron Watkins, Page 373.

WARNING:  Most portions of this document were written prior to the issuance of FASB Interpretation No. 46 in January 2003.  Most of those portions have not been revised in light of the newer interpretation.  For example, major portions of various Emerging Issues Task Force (EITF) issues that applied prior to January 2003, no longer apply.  The affected EITF issues include EITM Issue Numbers 10-15, 95-6, 96-21, 97-1, 97-2 and 84-30.  Prior message threads remain in this document to help historical researchers.  

Deloitte and Touche provides a nice summary of FIN 46. The new interpretation was prompted in large measure by the fraudulent use of offshore special purpose entities (now called variable interest entities).

The link for your friends and family is at http://www.deloitte.com/dtt/newsletter/0,2307,sid%253D2002%2526cid%253D35660,00.html 

UNEQUAL TREATMENT:  Rotten to the Core

"Playing Favorites:  Why Alan Greenspan's Fed lets banks off easy on corporate fraud," by Ronald Fink, CFO Magazine, April 2004, pp. 46-54 --- http://www.cfo.com/article/1,5309,12866||M|886,00.html 

The module below is not in the above online version of the above article.  However, it is on Page 51 of the printed version.

UNEQUAL TREATMENT

IF THE FEDERAL RESERVE BOARD AND THE SECURITIES AND EXCHANGE Commission pursue the same agenda, why were Merrill Lynch & Co. and the Canadian Imperial Bank of Commerce (CIBC) treated so differently by the Corporate Fraud Task Force--a team with representatives from the SEC, the FBI, and the Department of Justice (DoJ) set up to prosecute perpetrators of Enron's fraud--than were Citigroup and J. P. Morgan Chase & Co.?  After all, all four banks did much the same thing.

Under settlements signed with the SEC last July, Citigroup and Chase were fined a mere $101 million (including $19 million for its actions relating to a similar fraud involving Dynegy) and $135 million, respectively, which amounts to no more than a week of either's most recent annual earnings.  And they agreed, in effect, to cease and desist from doing other structured-finance deals that mislead investors.  That contrasts sharply with the punishment meted out by the DoJ to Merrill and CIBC, each of which not only paid $80 million in fines, but also agreed to have their activities monitored by a supervising committee that reports to the DoJ.  Even more striking, CIBC agreed to exit not only the structured-finance business but also the plain-vanilla commercial--paper conduit trade for three years.  No regulatory agency involved in the settlements would comment on the cases, though the SEC's settlement with Citigroup took note of the bank's cooperation in the investigation.

But Brad S. Karp, an attorney with the New York firm Paul, Weiss, Rifkind, Wharton & Garrison LLP, suggested recently that the terms of the SEC settlement with its client, Citigroup, reflected a lack of knowledge or intent on the bank's part.  As Karp noted more than once at a February conference on legal issues and compliance facing bond-market participants, the SEC's settlement with Citigroup was ex scienter, a Latin legal phrase meaning "without knowledge."

However, the SEC's administrative order to Citigroup cited at least 13 instances where the bank was anything but in the dark about its involvement in Enron's fraud.

As Richard H. Walker, former director of the SEC's enforcement division and now general counsel of Deutsche Bank's Corporate and Investment Bank, puts it, all the banks involved in Enron's fraud "had knowledge" of it.  Yet Walker isn't surprised by their disparate treatment at the hands of regulators.  "The SEC does things its way," he says, "and the Fed does them another."  *Ronald Fink and Tim Reason

Bob Jensen's threads on "Rotten to the Core" are at http://www.trinity.edu/rjensen/FraudRotten.htm 

The FED versus the SEC:  Yet Another Example of Where Accounting Standards Are Not Neutral

"Playing Favorites:  Why Alan Greenspan's Fed lets banks off easy on corporate fraud," by Ronald Fink, CFO Magazine, April 2004, pp. 46-54 --- http://www.cfo.com/article/1,5309,12866||M|886,00.html 

When the Financial Accounting Standards Board released its exposure draft of new accounting rules for special-purpose entities (SPEs), in late 2002, the nation's financial regulators sent FASB chairman Robert H. Herz decidedly mixed signals.

On the one hand, the Securities and Exchange Commission wanted Herz to make the rules effective as soon as possible. SPEs were the prime vehicle for the fraud that brought Enron down, and were widely used by other companies to take liabilities off their balance sheets, obscure their financial condition, and obtain lower-cost financing than they deserved. Not surprisingly, the SEC was anxious to head off other financial fiascos resulting from such abuse.

At the same time, however, the Federal Reserve Board pressed Herz to slow down. That's because the new rules threatened to complicate the lives of the Fed's most important charges: large, multibusiness bank holding companies that happen to earn sizable fees by arranging deals involving SPEs. Stuck between this regulatory rock and hard place, Herz told the Fed and the SEC to get together and work out a timetable that satisfied both constituencies.

And they did. But the rules, known as FIN 46 (FASB Interpretation No. 46), have only recently taken effect in some cases, and have yet to do so in others. While the delay in the rules' effective date may reflect the complexity of the transactions covered by FIN 46 as much as the controversy generated by the rules themselves, the conflict between the Fed and the SEC over the matter stems from a deeper problem: the Fed and the SEC have very different regulatory missions that can sometimes come into serious conflict.

The problem surfaced in December 2002 during congressional hearings on the extensive role that certain banks—including Citigroup, J.P. Morgan Chase & Co., and Merrill Lynch & Co.—played in deceptive transactions involving Enron SPEs. Those hearings by the Senate Permanent Subcommittee on Investigations, led by Sen. Carl Levin (D-Mich.), identified what he and then­ranking minority member Sen. Susan M. Collins (R-Maine) termed "a current gap in federal oversight" of the banks that helped them aid and abet Enron's fraud. "The SEC does not generally regulate banks, and bank regulators do not generally regulate accounting practices overseen by the SEC," notes the report, which went on to say that this "is a major problem and needs immediate correction."

That correction has yet to be made. The onus of doing so is on the Fed, as the chief regulator of the nation's financial system. Yet Fed chairman Alan Greenspan shows little inclination to do much about the problem.

Yes, the markets have recovered from Enron, at least for the time being. But the penalties and other punishment that regulators meted out to the banks for their role in the fraud display at best a worrisome inconsistency. And that suggests that problems arising from the regulatory gap identified by senators Levin and Collins could recur. Unless the gap is closed, it could undermine other regulatory efforts aimed at improving corporate governance. That, in turn, might have a short-term impact on investor confidence, still fragile some two years after Enron's failure. And in the long term, future Enrons could slip through the gap undetected.

If nothing else, the question of what should be done about it deserves a place on the agenda when the Senate considers Greenspan's nomination for a fifth term, as is expected after his current four-year stint ends in June.

No Firewalls
To be sure, both Citigroup and Chase agreed, after their role at Enron was exposed, to avoid new financing arrangements that pose similar legal and reputational risk. And under FIN 46, all deals involving SPEs must be disclosed on the balance sheet of either the bank, the borrower, or a third party. But it remains to be seen how effective the new rules will be in preventing future off-balance-sheet frauds (see "Longer Paper Routes").

Complicating matters is the combination of commercial and investment banking and insurance blessed by the Gramm-Leach-Bliley Act of 1999, which ended the last vestiges of separation enacted by the Glass-Steagall Act and made the Fed the financial system's primary regulator. But while the central bank supervises private banks involved in these lines of business, including Citigroup and Chase, the Fed's primary interest isn't stopping financial fraud, but making sure the U.S. banking system remains safe and sound. "The Fed doesn't even believe in firewalls," says Dimitri B. Papadimitriou, president of the Levy Economics Institute at Bard College.

Continued in the article

Bob Jensen's threads on "Rotten to the Core" are at http://www.trinity.edu/rjensen/FraudRotten.htm 

Bob Jensen's threads on SPEs, VIEs, and FIN 46 are below.

Introduction (Definitions and Simple Examples)

Synthetic Leasing

FASB Summary Report

Revised FIN 46 Interpretation of Accounting Research Bulletin No. 51, Consolidated Financial Statements

FASB Q & A

SEC Guidelines

From the Financial Management Association (FMA) :  The Kavanagh Report

Financial Executives International (FEI) Research Report 

Enron Auditor Carl Bass Disclosures in 1999 

Enron's Board of Directors Research:  The Powers Report

Enron's Whistle Blower:  The Watkins Letter

News Reports and Miscellaneous Items 

Introduction (Definitions and Simple Examples)

Warning: In quotations you will sometimes find the 3% outsider minimum investment requirement in an SPE.  In Year 2002 following the Enron/Andersen scandals, the FASB raised this to 10%.   See FIN 46 below.

Bob Jensen's threads on the Enron/Andersen scandals are at http://www.trinity.edu/rjensen/fraud.htm 

EITF = Emerging Issue Task Force of the Financial Accounting Standards Board (FASB).  The EITF evaluates emerging issues in financial reporting and makes recommendations to the FASB regarding whether new or modified accounting standards are needed do to emerging issues.  For example, the issuance of FAS 13 resulted in emerging issues raised by banks and leasing companies regarding the heavy-handed impact of FAS 13 on certain types of leases.  The EITF is a large body that is comprised of many constituents, notably representatives from industry who often raise the issues.   The EITF issues pronouncements that are accounting guides prior to ultimate resolution of the FASB. 

There is no comprehensive FASB standard on SPE accounting.  Most of the guidelines for this accounting lies in various EITF guidelines.  The EITF guidelines are not standards, but they have a significant impact since auditing firms often insist that these guidelines be followed by their clients.  The clients such as General Electric, General Motors, and other large financing companies often play a key role in setting EITF guidelines and concerns about conflicts of interest in EITF guidelines are matters of concern.  A February 12, 2002 message from Eckman, Mark S, CFCTR [meckman@att.com] reads as follows:

The SPE module (Bob Jensen's SPE Overview) is very good.  I would like to add a couple of notes on the composition of the EITF to understand how we arrived at this point.

Since the inception of the EITF, 11 participants represent a 'Who's Who' of financial services and  companies that have major stakes in financial services.

Name	Firm
John R. Edman	General Motors Corporation
Bernard R. Doyle	General Electric Company
Philip D. Ameen	General Electric Company
Susan S. Bies	First Tennessee National Corporation
Peter E. Jokiel	CNA Insurance Companies
Thomas E. Jones	Citicorp
Paul B. Lukens	CIGNA Corporation
Kathy F. Zirolli	Aetna, Inc.
Marc D. Oken	NationsBank Corporation
David H. Sidwell	J.P. MorganChase
Gaylen N. Larson	Household International, Inc.

Also, three previous members of the EITF have moved to positions on the FASB, including the current Chair.  Considering a total population of only 85 participants, these are rather significant representations.

While the profession has begun to address the independence of the auditor and auditee on a serious basis, vested interests abound that have not been discussed. 

SPE = Special Purpose Entity that allows "sponsor/originator" companies bearing as much as 90% of the SPE's debt risk to keep that debt off the consolidated balance sheet under U.S. Generally Accepted Accounting Principles.  Enron's double dealing former CFO Andy Fastow and former CEO Jeff Skilling changed the definition of SPE to S _ _ t Piled Everywhere!  But the majority of SPEs in the world are perfectly legitimate.  Special SPE accounting arose largely due to pressures from banks and leasing companies to provide a way to avoid capitalization (booking) of special types of leases following the FAS 13 change in leasing rules that stiffened the requirements for booking of "capital" leases.  There are some financing and tax benefits of SPEs, although the primary motivation is often to achieve off-balance sheet financing (OBSF).  Not all SPEs involve lease financing, but the motivation usually is to achieve some form of OBSF accounting.

From the AccountingWeb --- http://www.accountingweb.com/cgi-bin/item.cgi?id=91819

FASB Issues FAS 147, Holds Roundtable on SPEs

AccountingWEB US - Oct-2-2002 -  The Financial Accounting Standards Board (FASB) issued Statement No. 147 on "Acquisitions of Certain Financial Institutions" and held a roundtable discussion on accounting for special purpose entities (SPEs). FAS 147. Statement 147 fills in one of the gaps left when FASB issued Statements No. 141, "Business Combinations," and No. 142, "Goodwill and Other Intangible Assets." The new standard revises portions of Statement 72, which was developed as a "practical solution" to avoid creating reported earnings from purchase accounting in times when interest rates were at historical highs and many financial institutions were reporting losses. An article written by FASB practice fellow Brian Degano answers frequently asked questions about the project.   SPEs. Separately, on September 30, FASB held a roundtable discussion on accounting for special purpose entities. According to press accounts, opinion was divided on the need for a speedy resolution of the matter versus the need for a thorough review of the issues. Securities and Exchange Commission (SEC) Deputy Chief Accountant Jackson Day stressed the need for speed. But Stephen Brookshire, managing principal of Atlantic Financial Group, likened the standard-setting initiative to "taking a bazooka to bird-hunting." Other concerns focused on the proposed effective date of March 15, 2003, which coincides with SEC filing deadlines for calendar-year companies, along with the potential need to consolidate an SPE, then later deconsolidate it due to a change in investors. ("SEC: Imperative to finalize new SPE accounting rules by year-end," Wall Street Journal, September 30, 2002.)

SPV = Special Purpose Vehicle that will be viewed as a synonym for SPE in this document.

VIE = Variable Interest Entity.  VIE is now the term now used by the FASB in place of the older term SPE.  Since the crash of Enron, SPE has had a negative connotation.  The FASB now prefers the term VIE to depict a special entity in which the developing sponsor may have a varying interest in the financial risk.

QSPE = Qualified Special Purpose Entity under the FAS 140 Standard.  QSPEs enjoy special privileges under FAS 140, but must meet a number of qualification criteria. One of these is that QSPEs may not exercise an impermissible degree of discretion in managing the assets which they hold, which are the principal source of cash flows supporting payments on the related securities.  Aside from OBSF motivations, there are real economic incentives that may arise due to the following possibilities that make SPEs and SPVs "special"::

• The financial risk of the sponsor of may be limited to its investment or explicit recourse obligation in the SPE or SPV.  In many instances, creditors of a bankrupt SPE or SPV cannot seek additional assets from the sponsor beyond what was invested or contracted for by that sponsor.  In other words, the sponsor may not become the deep pockets for damages exceeding the assets of the SPE or SPV.   The verb "may be" is not as strong as "cannot be."   The reason is that the contracts between the sponsor and the SPE or SPV may be quite complex and obtain conditional clauses that obligate the sponsor to provide additional assets or its own stock when certain "trigger events" take place that require early liquidation or other actions to protect creditors of the SPE or SPV.

The net assets of the SPE or SPV may be protected from creditors of its sponsors such that the SPE or SPV is not the deep pockets in the event that any sponsor goes bankrupt.  This protection sometimes allows the SPE or SPV to obtain financing at a lower cost than the sponsor can obtain financing.

"Jurors Were Divided Over Morgans Lawsuit," BLOOMBERG NEWS, January 4, 2003

Jurors who were about to weigh J. P. Morgan Chase's $965 million claim against 11 insurers over Enron oil and gas trades said yesterday that they had been split before the opponents in the lawsuit reached a settlement. The insurers agreed on Thursday to a settlement that allowed them to pay $503 million to $579 million on six surety bonds, ending a monthlong trial in federal court in Manhattan just as jury deliberations were to begin. Four of the six jurors said in a group interview that they had been divided on whether the insurers should pay and had expected to spend days deciding the outcome. The trial showed that the insurers and J. P. Morgan Chase, whose shares rose 6 percent after the settlement, failed to do enough research about the risks of the oil and gas transactions, the jurors said. The dispute was part of the fallout from the accounting scandal that led to Enron's collapse and bankruptcy more than a year ago.

"These are big boys and they both should have settled it instead of wasting everybody's time," Gary Tannenbaum, a juror who works in real estate management, said of the J. P. Morgan Chase suit. "It's sort of embarrassing to me that big business is conducting business the way that they did." Under the settlement, the insurers could pay the bank as much as $579 million in cash, or they could pay $503 million and assign their Enron bankruptcy claims to the bank. Ten of 11 insurers opted for the lower payments. A spokesman for the Fireman's Fund Insurance Company, a unit of Allianz, could not immediately provide details of the company's plans.

The bank's shares rose 50 cents, to $25.94. J. P. Morgan Chase sued to force the insurers to pay the bonds. The insurers claimed they were tricked into backing disguised loans between the bank and Enron that looked like commodity trades. The trades involved Mahonia Ltd., a bank-sponsored "special purpose vehicle" in the Channel Island

Credit Enhancements = contractual terms in the SPE contract that provide a sponsor's guaranteed minimum net asset value of the SPE.   Because of credit enhancements needed to either obtain SPE loans or reduce the cost of these loans, the sponsor's assets are not generally totally shielded from SPE default litigation.  The terms of the enhancements themselves determine what the ultimate sponsor's risk is in a worst-case scenario.

Synthetic Lease = a financing structured to be treated as a lease for accounting purposes and a loan for tax purposes. The structure is used by corporations that are seeking OBSF reporting of their asset based financing, and that can efficiently use the tax benefits of owning the financed asset.

Structured Financing/Transaction = the isolation of assets and obligations in a "structure" apart from the main operations of  sponsors.  The structure is typically called a SPE or SPV.   It's cost of capital may differ from that of the sponsors, and the sponsors' control over the structure is generally much more limited than in the case of unstructured financings.  Often the management of the SPE or SPV is contracted to a trustee who must be independent of the sponsors.  The trustee's discretion, in turn, is limited to certain types of transactions such a mortgage investing, project construction, project leasing, etc.  The following types of structures are most common in practice:

• Cash Flow Structure  (Sponsors Receive Cash for Asset Sales to the SPE)

1. Each sponsor factors (sells) ownership of actual assets (e.g., receivables "factoring") to the structure.  Assets are deleted from the sponsor's balance sheet.  Multiple sponsors may use the same SPE such as when banks sell mortgage investments to a "mortgage pool" SPE.  Initially, SPE cash used to purchase the assets generally comes from the 3% (now 10%) invested by  the SPE's independent, up-front investor who is totally independent of the SPE sponsors/originators.   Cash used to purchase more assets later on from a sponsor may come from cash flows (e.g., interest income) generated from the SPE's assets, sales of its assets, or borrowing by the SPE.   Contractual limits may be placed upon SPE asset sales, borrowing, and securitization.   A drawback of cash flow structures is that gains reported on asset sales are taxable.
   
   
2. The sponsors record the transfer of the assets as a sales under FAS 140 or other GAAP rules.  Gains and losses are based upon estimated fair value at the time of the transfer.  This is an area of great concern to auditors since some sponsors like Enron corporation estimate fair values well above realistic fair values and, thereby, beef up their own earnings per share with questionable levels of recorded sales to SPEs.  This is one of the alleged abuses of SPEs by Enron and other energy traders who revised previous financial reports following the media publicity of questionable fair value estimates.
   
   
3. The transferred assets are protected from lawsuits against the sponsor, although the sponsors may have to add more "assets" based upon contractual trigger events.  Trigger events such as the severe declines in the net value of an SPE may require that sponsors add more assets and/or their own equity shares to the SPE. 
   
   
4. The transferred assets may serve as security (securitization) for borrowing by the SPE, and the cash flows from the assets and borrowings may be used to purchase additional assets from the sponsors.
   
   
5. Some SPEs may purchase equity shares of the sponsor for cash, or equity shares may be directly transferred to cover trigger event declines in an SPE's net asset value.   Transferred sponsors' equity shares become "assets" of the SPE that in turn have their own contractual triggers.  As long as equity shares can be sold for immediate cash in the stock market at prices exceeding callable SPE debt, no crisis arises from holding equity shares of sponsors.
   
   For example, it is alleged that the collapse of Enron would not have arisen in late 2001 had Enron share prices not fallen below $80 per share.  Plunging share prices hit SPE trigger points below $80 per share that allowed the SPEs' creditors to demand early collections on an SPEs' debt.  The Enron shares held by some SPEs could not be sold for sufficient cash to cover the early terminations. 
   
   Enron was strapped for cash and could not cover the triggered obligations with its own corporate cash.  Enron SPEs became a house of stacked cards based upon Enron share prices.  Enron SPEs did not have sufficient assets aside from Enron shares to cover the called-in debt.  This problem was exacerbated by Enron's inflated sales values for transferred receivables and by collection (bad debt) difficulties in many of the transferred receivables. 
   
   Since the only thing available to cover the decline in SPE asset values was Enron share values, this created what the infamous Enron whistle blower (Ms Watkins) called not having real "skin" to keep the SPEs from failing when creditors called in the debt under contracted trigger events.
   
   
6. This is an example of a case where there is economic benefit (because of achieving fixed rate debt at a lower rate than would otherwise be available without the SPE) and the cosmetic benefit (of not having the long-term, fixed rate debt ever be booked as a liability on the sponsor's balance sheet.)

• Derivatives Financial Instrument Structure in Lieu of an Asset Transfer

1. As an example, suppose that a sponsor enters into forward sales contracts for product from a plant such as Enron's forward energy sales contracts in India for an enormous new power plant built by Enron.   Suppose the plant is originally financed with floating rate, short-term debt until the plant begins to generate electricity.
   
   
2. Once the plant is operational, the sponsor's  forward contracts (one type of derivative instrument) can be transferred to an SPE that in turn uses these forward contracts as collateral to borrow an enormous amount of cash on fixed rate notes at having a lower rates than the sponsor could otherwise obtain on its own (because the sponsor's other debt raises the cost of capital, whereas the SPE is shielded from the sponsor's other creditors).    After using the sale proceeds to pay off construction loan, the sponsor (e.g., Enron) no longer has floating rate interest risk and retains title to the plant, although the plant itself may have to serve as additional collateral to obtain the fixed rate debt.  For example, Enron's forward sales contracts in India were reneged upon (not necessarily without good reason given the questionable way they were obtained), and Enron itself declared bankruptcy leaving the recovery of the construction loans by banks in doubt until the courts in the U.S. and India decide how to reimburse creditors for the construction loans.
   
   
3. If the Enron's venture had proceeded according to plan, SPE's sponsor (Enron) would receive cash from the sale of the forward contracts, and then pay off its short-term, floating rate construction debt with this cash.  The sponsor, thereby, has achieved OBSF financing of its enormous power plant through the use of forward sales contract derivative financial instruments.  When the SPE's long-term, fixed-rate debt is paid off, the SPE goes out of business and energy sales revenue not needed to service debt or pay off the outside SPE investor reverts back to the sponsor.  The entire venture, thereby, if financed off balance sheet once the power plant commences producing electricity.
   
   
4. When the forward sales contracts mature over time, those energy sales at forward prices are used to service the SPE fixed rate debt.  In Enron's case, India ultimately objected to the high forward prices negotiated by an official who received many valuable personal perks from Enron.
   
   
5. Various other types of derivative instruments such as swaps might be used to obtain similar objectives.
   
   
6. This is an example of a case where there is economic benefit (because of achieving fixed rate debt at a lower rate than would otherwise be available without the SPE) and the cosmetic benefit (of not having the long-term, fixed rate debt ever be booked as a liability on the sponsor's balance sheet.  Risk and returns are probably not a whole lot different than if the power plant had been sold to the SPE (as illustrated above for a cash flow structure instead of a derivative financial instruments structure).

• Diamond Structure

1. A diamond structure arises when three or more sponsors form an SPE where no one sponsor has control over the SPE.  This type of SPE is common when the sponsors can provide securitization with long-term throughput or take--or-pay contracts.   Diamond structures may be separate corporations that not even meet the definition of a SPE and yet function exactly like an SPE.
   
   
2. For example, suppose three major oil companies (sponsors) want to build a pipeline.  A pipeline corporation is formed with each sponsor owning  a third of the voting shares.  The sponsors invest little if any cash in the pipeline company.  However, the pipeline company can borrow millions or even billions based upon long-term throughput contracts signed by the partners to purchase millions of gallons of fuel carried each year in the completed pipeline.
   
   
3. The throughput contracts are essentially forward contracts to purchase throughput, revenues from which go to service the pipeline's debt and to operate the pipeline.  Similar contracts can arise with take-or-pay contracts such as long-term purchasing contracts from a new oil refinery.

• Defeasance (In Substance Defeasance)

1. Defeasance OBSF was invented over 20 years ago in order to report a $132 million gain on $515 million in bond debt.   An SPE was formed in a bank's trust department (although the term SPE was not used in those days).  The bond debt was transferred to the SPE and the trustee purchased risk-free government bonds that, at the future maturity date of the bonds, would exactly pay off the balance due on the bonds as well as pay the periodic interest payments over the life of the bonds.
   
   
2. At the time of the bond transfer, Exxon captured the $132 million gain that arose because the bond interest rate on the debt was lower than current market interest rates.  The economic wisdom of defeasance is open to question, but its cosmetic impact on balance sheets became popular in some companies until  defeasance rules were changed first by FAS 76 and later by FAS 125.
   
   
3. Exxon removed the $515 million in debt from its consolidated balance sheet even though it was technically still the primary obligor of the debt placed in the hands of the SPE trustee.  Although there should be no further risk when the in substance defeasance is accomplished with risk-free government bond investments, FAS 125 in 1996 ended this approach to debt extinguishment.  FASB Statement No. 125 requires derecognition of a liability if and only if either (a) the debtor pays the creditor and is relieved of its obligation for the liability or (b) the debtor is legally released from being the primary obligor under the liability. Thus, a liability is not considered extinguished by an in-substance defeasance.

• Synthetic Lease Structure (Sponsors Sell the Asset to the SPE and Then Lease It Back)

1. A common approach is for the sponsor to sell the asset to the SPE and then lease it back from the SPE via what is known as synthetic leasing.  A synthetic lease is structured under FAS 140 rules such that a sale/leaseback transaction takes place where the fair value of the assets "sold" can be reported by the sponsor as "revenue" for financial reporting.  In a synthetic lease, this "revenue" does not have to be reported up-front for tax purposes even though it is reported up-front for financial reporting purposes. 
   
   
2. Proceeds from the sale to an SPE in this instance are generally long-term receivables rather than cash (which is the primary reason the sale revenues are not taxed up-front).
   
   
3. The synthetic leaseback terms are generally such that the sponsor does not have to book the leased asset or the lease liability under FAS 13 as a capital lease (i.e., some clause in the lease contract allows the asset to be kept off balance sheet as an operating lease).  Hence the financing of the lease asset remains off balance sheet.  This is one ploy used by airlines and oil companies to keep assets and "debt" off the balance sheet as well as deferring taxes.
   
   
4. If the SPE actually manages the transferred assets (e.g., a pipeline or a refinery), then throughput or take-or-pay contracts may take the place of leasing.

FIN 46 

Deloitte and Touche provides a nice summary of FIN 46. The new interpretation was prompted in large measure by the fraudulent use of offshore special purpose entities (now called variable interest entities).

The link for your friends and family is at http://www.deloitte.com/dtt/newsletter/0,2307,sid%253D2002%2526cid%253D35660,00.html 

In September 2003, the FASB issued Parts a, b, c, d, and e of it's interpretations of FIN 46 on Consolidation of Variable Interest Entities --- http://www.fasb.org/fasb_staff_positions/prop_fsp_fin46-e.pdf 

Revised FIN 46 Interpretation of Accounting Research Bulletin No. 51, Consolidated Financial Statements,
From the January 17, 2003 FEI Express

Those FEI members whose companies have November 30 or December 31 fiscal year-ends need to take a close look at FASB Interpretation No. 46, Consolidation of Variable Interest Entities, as soon as possible for two reasons: (1) FIN 46 has disclosure requirements that become effective for financial statements issued after January 31, 2003; (2) FIN 46 applies to all types of unconsolidated entities (e.g., joint ventures, partnerships, cost basis investments, etc.). For those who have not followed this project closely, FIN 46 could affect your company's financial statements even if it has no involvement with so-called "special purpose entities" (SPEs). The following is a brief synopsis of the rule. The complete document is available now at the FASB's web site at: http://www.fasb.org/interp46.pdf.

Transactions that will come under FIN 46 scrutiny include the following:

• off-balance-sheet R&D ventures, 

• synthetic leases, 

• asset-backed commercial paper, 

• collateralized debt obligation, and 

• exploration ventures, 

• others.

A summary of the new interpretation is as follows:

This Interpretation of Accounting Research Bulletin No. 51, Consolidated Financial Statements, addresses consolidation by business enterprises of variable interest entities, * which have one or both of the following characteristics: 

1. The equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, which is provided through other interests that will absorb some or all of the expected losses of the entity. 

2. The equity investors lack one or more of the following essential characteristics of a controlling financial interest: 

a. The direct or indirect ability to make decisions about the entity’s activities through voting rights or similar rights 

b. The obligation to absorb the expected losses of the entity if they occur, which makes it possible for the entity to finance its activities 

c. The right to receive the expected residual returns of the entity if they occur, which is the compensation for the risk of absorbing the expected losses. 

The following are exceptions to the scope of this Interpretation: 

1. Not-for-profit organizations are not subject to this Interpretation unless they are used by business enterprises in an attempt to circumvent the provisions of this Interpretation. 

2. Employee benefit plans subject to specific accounting requirements in existing FASB Statements are not subject to this Interpretation. 

3. Registered investment companies are not required to consolidate a variable interest entity unless the variable interest entity is a registered investment company. 

4. Transferors to qualifying special-purpose entities and “grandfathered” qualifying special-purpose entities subject to the reporting requirements of FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, do not consolidate those entities.

5. No other enterprise consolidates a qualifying special-purpose entity or a “grandfa-thered” qualifying special-purpose entity unless the enterprise has the unilateral ability to cause the entity to liquidate or to change the entity in such a way that it no longer meets the requirements to be a qualifying special-purpose entity or “grandfathered” qualifying special-purpose entity. 

6. Separate accounts of life insurance enterprises as described in AICPA Auditing and Accounting Guide, Life and Health Insurance Entities, are not subject to this Interpretation. 

Reason for Issuing This Interpretation 

Transactions involving variable interest entities have become increasingly common, and the relevant accounting literature is fragmented and incomplete. 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. 

The objective of this Interpretation is not to restrict the use of variable interest entities but to improve financial reporting by enterprises involved with variable interest entities. The Board believes that if a business enterprise has a controlling financial interest in a variable interest entity, the assets, liabilities, and results of the activities of the variable interest entity should be included in consolidated financial statements with those of the business enterprise. 

Differences between This Interpretation and Current Practice 

Under current practice, two enterprises generally have been included in consolidated financial statements because one enterprise controls the other through voting interests. This Interpretation explains how to identify variable interest entities and how an enterprise assesses its interests in a variable interest entity to decide whether to consolidate that entity. This Interpretation requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. Variable interest entities that effectively disperse risks will not be consolidated unless a single party holds an interest or combination of interests that effectively recombines risks that were previously dispersed.

An enterprise that consolidates a variable interest entity is the primary beneficiary of the variable interest entity. The primary beneficiary of a variable interest entity is the party that absorbs a majority of the entity’s expected losses, receives a majority of its expected residual returns, or both, as a result of holding variable interests, which are the ownership, contractual, or other pecuniary interests in an entity. The ability to make decisions is not a variable interest, but it is an indication that the decision maker should carefully consider whether it holds sufficient variable interests to be the primary beneficiary. An enterprise with a variable interest in a variable interest entity must consider variable interests of related parties and de facto agents as its own in determining whether it is the primary beneficiary of the entity. 

Assets, liabilities, and noncontrolling interests of newly consolidated variable interest entities generally will be initially measured at their fair values except for assets and liabilities transferred to a variable interest entity by its primary beneficiary, which will continue to be measured as if they had not been transferred. If recognizing those assets, liabilities, and noncontrolling interests at their fair values results in a loss to the consolidated enterprise, that loss will be reported immediately as an extraordinary item. If recognizing those assets, liabilities, and noncontrolling interests at their fair values would result in a gain to the consolidated enterprise, that amount will be allocated to reduce the amounts assigned to assets in the same manner as if consolidation resulted from a business combination. However, assets, liabilities, and noncontrolling interests of newly consolidated variable interest entities that are under common control with the primary beneficiary are measured at the amounts at which they are carried in the consolidated financial statements of the enterprise that controls them (or would be carried if the controlling entity prepared financial statements) at the date the enterprise becomes the primary beneficiary. 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. In some circumstances, earnings of the variable interest entity attributed to the primary beneficiary arise from sources other than investments in equity of the entity. 

An enterprise that holds significant variable interests in a variable interest entity but is not the primary beneficiary is required to disclose (1) the nature, purpose, size, and activities of the variable interest entity, (2) its exposure to loss as a result of the variable interest holder’s involvement with the entity, and (3) the nature of its involvement with the entity and date when the involvement began. The primary beneficiary of a variable interest entity is required to disclose (a) the nature, purpose, size, and activities of the variable interest entity, (b) the carrying amount and classification of consolidated assets that are collateral for the variable interest entity’s obligations, and (c) any lack of recourse by creditors (or beneficial interest holders) of a consolidated variable interest entity to the general credit of the primary beneficiary.

How This Interpretation Will Improve Financial Reporting 

This Interpretation is intended to achieve more consistent application of consolidation policies to variable interest entities and, thus, to improve comparability between enterprises engaged in similar activities even if some of those activities are conducted through variable interest entities. Including the assets, liabilities, and results of activities of variable interest entities in the consolidated financial statements of their primary beneficiaries will provide more complete information about the resources, obligations, risks, and opportunities of the consolidated enterprise. Disclosures about variable interest entities in which an enterprise has a significant variable interest but does not consolidate will help financial statement users assess the enterprise’s risks. 

How the Conclusions in This Interpretation Relate to the Conceptual Framework 

FASB Concepts Statement No. 1, Objectives of Financial Reporting by Business Enterprises, states that financial reporting should provide information that is useful in making business and economic decisions. Including variable interest entities in consolidated financial statements with the primary beneficiary will help achieve that objective by providing information that helps in assessing the amounts, timing, and uncertainty of prospective net cash flows of the consolidated entity. 

Completeness is identified in FASB Concepts Statement No. 2, Qualitative Characteristics of Accounting Information, as an essential element of representational faithfulness and relevance. Thus, to faithfully represent the total assets that an enterprise controls and liabilities for which an enterprise is responsible, assets and liabilities of variable interest entities for which the enterprise is the primary beneficiary must be included in the enterprise’s consolidated financial statements. 

FASB Concepts Statement No. 6, Elements of Financial Statements, defines assets, in part, as probable future economic benefits obtained or controlled by a particular entity and defines liabilities, in part, as obligations of a particular entity to make probable future sacrifices of economic benefits. The relationship between a variable interest entity and its primary beneficiary results in control by the primary beneficiary of future benefits from the assets of the variable interest entity even though the primary beneficiary may not have the direct ability to make decisions about the uses of the assets. Because the liabilities of the variable interest entity will require sacrificing consolidated assets, those liabilities are obligations of the primary beneficiary even though the creditors of the variable interest entity may have no recourse to the general credit of the primary beneficiary.

At its September 17, 2003 Board Meeting, the Board will consider:
Whether to provide a limited-scope exception for a reporting entity's interest in a variable interest entity, or potential variable interest entity, when:

1. The variable interest entity or potential variable interest entity existed as of the Interpretation's issuance and effective dates, and
2. The reporting entity, after making exhaustive efforts, is unable to obtain information necessary to determine if the entity is a variable interest entity or to determine whether the reporting entity is the primary beneficiary of the variable interest entity.

The Board also will consider whether to direct the staff to issue a proposed FASB Staff Position (FSP) to defer the effective date of Interpretation 46 until the end of the first interim or annual period ending after December 15, 2003, for an interest held by a public entity in a variable interest entity that (a) was not previously considered to be a special-purpose entity and (b) has assets that are predominately nonfinancial. Examples of the types of interest to be considered by the Board are franchise arrangements, supplier arrangements, and troubled debt restructurings.

Hi Erin,

I don't really have much more to help you. You should be aware that the FASB postponed FIN 46 and put three new Proposed Staff Positions FIN 46a, FIN 46b, and FIN 46c out for discussion. These are on the current first page of http://www.fasb.org/ 

You might take a look at the following documents:

 http://www.grantthornton.com/content/81782.asp?bhjs=1&bhsw=800&bhsh=600&bhswi=771&bhshi=423&bhflver=5&bhdir=0&bhje=1&bhcold=32&bhrl=-1&bhqt=-1&bhmp=-1&bhab=-1&bhmpex=&bhflex=6,0,79,0&bhdirex=&bhcont=lan 

I shortened that horrible URL to http://snipurl.com/GrantThorntonFAS46  
"FIN 46 may build up business' balance sheet," Grant Thornton, June 24, 2003

http://www.vinodkothari.com/fin46vk.htm  
"FIN 46: consolidation of variable interest entities under US GAAPs," by Vinod Kothari

A Deloitte and Touche Slide Show on FIN 46 --- http://www.cbe.uidaho.edu/Acct592/CourseMaterials/Lecture%20Notes/Deloitte%20&%20Touche_fin46_012903%5B1%5D.ppt 

I shortened the above URL to http://snurl.com/DTSlideShowFIN46 

Bob Jensen

-----Original Message----- From: XXXXX 
Sent: Monday, September 15, 2003 9:12 PM 
To: Jensen, Robert 
Subject: SPE help

Dr. Jensen, My name is Erin XXXXX an I am an undergraduate Accounting student at The University of YYYYY. I have been doing some research on Special Purpose Entities for an Accounting Thesis that I am writing this semester and I came across your page titled "Bob Jensen's Overview of Special Purpose Entities." I found some very helpful information, but I was wondering if you had any links to information on the current FASB exposure draft, "Qualifying Special-Purpose Entities and Isolation of Transferred Assets." I am trying to decipher it, but it is difficult for me to understand because I do not have a good background in Finance and this is my first assignment involving reading actual FASB statements. I have found the topic to be interesting although very complex, but unfortunately I am far from an expert in this field and need some clarification on some of the terms in the draft. I would greatly appreciate any information you may have. 

Thank you, 
Erin

On December 24, 2003, the FASB published a revision to Interpretation 46 as a Christmas present to clarify and expand on accounting guidance for variable interest entities. The additional guidance is in response to comments received from constituents. The complete revised Interpretation 46 is available on the FASB's website --- http://www.fasb.org/fin46r.pdf 

Summary

    This Interpretation of Accounting Research Bulletin No. 51, Consolidated Financial Statements, which replaces FASB Interpretation No. 46, Consolidation of Variable Interest Entities, addresses consolidation by business enterprises of variable interest entities, which have one or more of the following characteristics:

1. The equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support provided by any parties, including the equity holders.

2. The equity investors lack one or more of the following essential characteristics of a controlling financial interest:
   a.    The direct or indirect ability to make decisions about the entity's activities through voting rights or similar rights.
   b.    The obligation to absorb the expected losses of the entity.
   c.    The right to receive the expected residual returns of the entity.

3. The equity investors have voting rights that are not proportionate to their economic interests, and the activities of the entity involve or are conducted on behalf of an investor with a disproportionately small voting interest.

The following are exceptions to the scope of the Interpretation:

1. Not-for-profit organizations are not subject to this Interpretation unless they are used by business enterprises in an attempt to circumvent the provisions of this Interpretation.

2. Employee benefit plans subject to specific accounting requirements in existing FASB Statements are not subject to this Interpretation.

3. Registered investment companies are not required to consolidate a variable interest entity unless the variable interest entity is a registered investment company.

4. Transferors to qualifying special-purpose entities and "grandfathered" qualifying special-purpose entities subject to the reporting requirements of FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, do not consolidate those entities.

5. No other enterprise consolidates a qualifying special-purpose entity or a "grandfathered" qualifying special-purpose entity unless the enterprise has the unilateral ability to cause the entity to liquidate or to change the entity in such a way that it no longer meets the requirements to be a qualifying special-purpose entity or "grandfathered" qualifying special-purpose entity.

6. Separate accounts of life insurance enterprises as described in the AICPA Auditing and Accounting Guide, Life and Health Insurance Entities, are not subject to this Interpretation.

7. An enterprise with an interest in a variable interest entity or potential variable interest entity created before December 31, 2003, is not required to apply this Interpretation to that entity if the enterprise, after making an exhaustive effort, is unable to obtain the necessary information.

8. An entity that is deemed to be a business (as defined in this Interpretation) need not be evaluated to determine if it is a variable interest entity unless one of the following conditions exists:
   a.    The reporting enterprise, its related parties, or both participated significantly in the design or redesign of the entity, and the entity is neither a joint venture nor a franchisee.
   b.    The entity is designed so that substantially all of its activities either involve or are conducted on behalf of the reporting enterprise and its related parties.
   c.    The reporting enterprise and its related parties provide more than half of the total of the equity, subordinated debt, and other forms of subordinated financial support to the entity based on an analysis of the fair values of the interests in the entity.
   d.    The activities of the entity are primarily related to securitizations, other forms of asset-backed financings, or single-lessee leasing arrangements.

9. An enterprise is not required to consolidate a governmental organization and is not required to consolidate a financing entity established by a governmental organization unless the financing entity (a) is not a governmental organization and (b) is used by the business enterprise in a manner similar to a variable interest entity in an effort to circumvent the provisions of this Interpretation.

Reason for Issuing This Interpretation

   Transactions involving variable interest entities have become increasingly common, and the relevant accounting literature is fragmented and incomplete.  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.

   The objective of this Interpretation is not to restrict the use of variable interest entities but to improve financial reporting by enterprises involved with variable interest entities.  The Board believes that if a business enterprise has a controlling financial interest in a variable interest entity, the assets, liabilities, and results of the activities of the variable interest entity should be included in consolidated financial statements with those of the business enterprise.

Differences between This Interpretation and Current Practice

   Under current practice, two enterprises generally have been included in consolidated financial statements because one enterprise controls the other through voting interests.  This Interpretation explains how to identify variable interest entities and how an enterprise assesses its interests in a variable interest entity to decide whether to consolidate that entity.  This Interpretation requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved.  Variable interest entities that effectively disperse risks will not be consolidated unless a single party holds an interest or combination of interests that effectively recombines risks that were previously dispersed.

   An enterprise that consolidates a variable interest entity is the primary beneficiary of the variable interest entity.  The primary beneficiary of a variable interest entity is the party that absorbs a majority of the entity's expected losses, receives a majority of its expected residual returns, or both, as a result of holding variable interests, which are the ownership, contractual, or other pecuniary interests in an entity that change with changes in the fair value of the entity's net assets excluding variable interests.  An enterprise with a variable interest in a variable interest entity must consider variable interests of related parties and de facto agents as its own in determining whether it is the primary beneficiary of the entity.

   Assets, liabilities, and  noncontrolling interests of newly consolidated variable interest entities generally will be initially measured at their fair values except for assets and liabilities transferred to a variable interest entity by its primary beneficiary, which will continue to be measured as if they had not been transferred.  However, assets, liabilities, and noncontrolling interests of newly consolidated variable interest entities that are under common control with the primary beneficiary are measured at the amounts at which they are carried in the consolidated financial statements of the enterprise that controls them (or would be carried if the controlling entity prepared financial statements) at the date of the enterprise becomes the primary beneficiary.  Goodwill is recognized only if the variable interest entity is a business as defined in this Interpretation.  Otherwise, the reporting enterprise will report an extraordinary loss for that amount.  After initial measurement, the assets, liabilities, and noncontrolling  interests of a consolidated variable interest entity will be accounted for as if the entity was consolidated based on voting interests.  In some circumstances, earnings of the variable interest entity attributed to the primary beneficiary arise from sources other than investments in equity of the entity.

   An enterprise that holds significant variable interests in a variable interest entity but is not the primary beneficiary is required to disclose (1) the nature, purpose, size, and activities of the variable interest entity, (2) its exposure to loss as a result of the variable interest holder's involvement with the entity, and (3) the nature of its involvement with the entity and date when the involvement began.  The primary beneficiary of a variable interest entity is required to disclose (a) the nature, purpose, size, and activities of the variable interest entity, (b) the carrying amount and classification of consolidated assets that are collateral for the variable interest entity's obligations, and (c) any lack of recourse by creditors (or beneficial interest holders) of a consolidated variable interest entity to the general credit of the primary beneficiary.

How This Interpretation Will Improve Financial Reporting

   This Interpretation is intended to achieve more consistent application of consolidation policies to variable interest entities and, thus, to improve comparability between enterprises engaged in similar activities even if some of those activities are conducted through variable interest entities.  Including the assets, liabilities, and results of activities of variable interest entities in the consolidated financial statements of their primary beneficiaries will provide more complete information about the resources, obligations, risks, and opportunities of the consolidated enterprise.  Disclosure about variable interest entities in which an enterprise has a significant variable interest but does not consolidate will help financial statement users assess the enterprise's risk.

In June 2003, the American Accounting Association's Financial Accounting Standards Committee issued the following:

"Comments on the FASB’s Proposals on Consolidating Special-Purpose Entities and Related Standard-Setting Issues," Accounting Horizons, June 2003, pp. 191-174 --- http://aaahq.org/ic/browse.htm 

The June 28, 2002 Financial Accounting Standards Board Exposure Draft (ED), Proposed Interpretation: Consolidation of Certain Special-Purpose Entities—an interpretation of ARB No. 51, addresses the consolidation of special-purpose entities (SPEs). Accounting Research Bulletin (ARB) No. 51 (AICPA 1959), Consolidated Financial Statements, does not apply to SPEs because they have no voting interests nor are they subject to control by means other than voting shares. This Accounting Horizons commentary presents the views of the American Accounting Association’s Financial Accounting Standards Committee (hereafter, the Committee) with respect to the ED.  An excerpt is shown below.

Application of a Principles-Based Consolidation Standard to SPEs

To illustrate the application of a principles-based consolidation standard to a situation contemplated by the ED, consider the case of a synthetic lease.  A company sets up an SPE to purchase and finance assets on its behalf, and the assets are then leased to the company via an operating lease.  The company-lessee typically does not have an equity position in the SPE, but effectively bears the risk and benefits of ownership of the leased assets through residual value guarantees.  Moreover, the company's use of the assets and the residual value guarantees provide direct evidence of the company's effective economic control over the SPE.  Accordingly, the company should consolidate the SPE under the Committee's approach to consolidation.

Another example involves a bank that creates an SPE to purchase receivables or debt instruments such as car loans or lease payments in the marketplace.  The assets are not top grade and require active management.  The SPE funds its purchases by issuing various tranches of debt and 10 percent equity.  As the asset manager, the bank receives a "market-based" fee and can be terminated after one year and annually thereafter by a majority vote of the debt holders.  The bank also provides a liquidity backstop that protects the debt holders against delayed payments, up to some limit.  The backstop does not protect the equity holders.

In this example, the bank does not control the assets; it is merely acting as an asset manager for the benefit of other stakeholders in the structure.  The presence of the guarantee, while exposing the bank to some risk, is no different than the types of guarantees that banks issue to other companies.  Thus, the Committee believes that the bank does not retain effective economic control over the SPE.  That is, it has not retained the risks and benefits of ownership, and should not consolidate the SPE.  Here, the objective should be to provide high-quality disclosure about the risks accepted by the bank.  (See, for example, the Committee's letter to the FASB on the Exposure Draft, Guarantor's Accounting and Disclosure Requirements, Including Indirect Guarantees of Indebtedness of Others, available at http://www.aaa-edu.org, or the related article published in Accounting Horizons [AAA FASC 2003a]).

HOW DOES THE ED COMPARE WITH OUR PERSPECTIVE ON A
PRINCIPLES-BASED CONSOLIDATION STANDARD?

This section outlines specific strengths and weaknesses of the ED relative to the Committee's view on a principles-based consolidation standard.

Strengths

The Committee believes that the ED moves accounting for SPEs from a rules-based standard toward a principles-based standard.  This is consistent with our preferred approach for a general consolidation standard and with our July 2002 letter commenting on conceptual standards, available at http://www.aaa-edu.org, or the related article published in Accounting Horizons (AAA FASC 2003b).  If approved, the ED would likely result in more SPEs being consolidated by the entities that have effective control over their operations, consistent with our general approach to consolidation.  The Committee favors moving the basis for consolidation from an emphasis on legal control to a notion of effective economic control, based on the concepts of variable interests and primary beneficiary.  This move toward an economic definition of control should improve financial reporting by enhancing the representational faithfulness of financial statements in those circumstances where the risks and benefits of ownership are retained.

Weaknesses

The Committee believes the ED has five potential weaknesses, which we discuss in turn:

• its limitation to specific transactions and its scope exceptions,

• a lack of clarity in the variable interests constructs,

• the inclusion of a bright-line rule for defining sufficient equity investment,

• the limited implementation guidance, and

• the absence of enhanced disclosure requirements.

The Hartgraves and Benston Papers 

COMMENTARY
"The Evolving Accounting Standards for Special Purpose Entities and Consolidations," by Al L. Hartgraves and George J. Benston, Accounting Horizons, September 2002, pp. 245-258.
The following are only selected excerpts.

This paper reviews the major actions taken by the accounting standard setters--the Financial Accounting Standards Board (FASB) and its Emerging Issues Task Force (EITF)--in connection with special purpose entities (SPEs) and traces the evolution of related authoritative guidance.  Accounting for SPEs entered public and professional prominence as a result of the Enron Corporation's failure.  The primary accounting issues regarding these entities are (1) whether they should be consolidated into the sponsor's¹ (or primary beneficiary's) financial statements or left "off-balance sheet," and (2) whether the sponsor should be able to treat gains and losses resulting from transactions with SPEs as independent, arm's-length transactions.  Critics harshly criticized Enron's auditor, Arthur Andersen, for allowing Enron to exclude from its financial statements the SPEs it sponsored, thereby keeping a substantial amount of debt off its balance sheet and recognizing substantially higher profits from transactions with SPEs.  We believe it is useful, therefore, to review both the authoritative guidance for the general area of consolidation of financial statements as well as guidance specific to SPEs.  This review also provides insight into how standard setting leading to changes in GAAP responds to changes in business practice, and how it might have been more effective in helping to prevent abuses in accounting for SPEs, such as those that ostensibly led to or exacerbated the downfall of Enron (Powers et al. 2002).

¹    The term "sponsor" is sometimes used to refer to the organization that legally creates the SPE, which may or may not be the primary beneficiary of the SPE.  At other times, and in this paper, it is used to refer to the company for whose primary benefit the SPE has been created.

WHAT ARE SPECIAL PURPOSE ENTITIES?

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 (GAAP) dealing with these entities.  Even though SPE financing vehicles have been around for about two decades, they failed to capture the attention of many participants in the mainstream of accounting discourse.  A search for references to SPEs in financial accounting textbooks yields virtually no results, and a search of the academic and professional accounting literature provides, at best, a limited explanation of this area of accounting.

Also called special purpose vehicles, SPEs typically are defined as entities created for a limited purpose, with a limited life and limited activities, and designed to benefit a single company.  They may take the legal form of a partnership, corporation, trust, or joint venture.  SPEs began appearing in the portfolio of financing vehicles that investment banks and financial institutions offered their business customers in the late 1970s to early 1980s, primarily to help banks and other companies monetize, through off-balance-sheet securitizations, the substantial amounts of consumer receivables on their balance sheets.  A newly created SPE would acquire capital by issuing equity and debt securities, and use the proceeds to purchase receivables from the sponsoring company, which often guaranteed the debt issued by the SPE.  Because the receivables have limited and reliably measured risk of nonrepayment, a relatively small amount of equity usually was sufficient to absorb all expected losses, thus making it unlikely that the sponsoring company would have to fulfill its guarantee.  In this way the sponsoring company could convert receivables into cash while paying a lower rate of interest than the alternative of debt or factoring, as the debt holder could be repaid from the collection of the receivables or the sponsor.  SPEs also allow the sponsors to remove receivables from their balance sheets, and avoid recognizing debt incurred in the securitization.

Other Uses of SPEs

Another major application in the early years of SPEs related to transactions involving the acquisition of plant and equipment under long-term lease contracts.  Companies could sponsor an SPE to acquire long-term assets with newly acquired debt and/or equity and enter into a contract to lease the assets from the SPE.  This often enabled companies to treat the contract as an operating lease for accounting purposes, thereby placing the asset and related debt on the SPE's balance sheet instead of that of the sponsoring company.

Other SPEs, typically organized as limited partnerships, also have been employed for more than 20 years to fund research and development (R&D) activities.  The sponsor often has only a contractual interest in the SPE, not an equity interest.  The crucial accounting issue for these SPEs, addressed in FASB Statement No. 68 (FASB 1982), is whether the sponsor has directly or indirectly agreed to repay the funds provided by the outside parties.  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.

SPE's and Off-Balance-Sheet Financing

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.  Other vehicles include operating leases, take-or-pay contracts, and throughput arrangements² that enable a company to use something in its future operations in exchange for agreed upon payments.  In these situations the accounting problem is to determine whether an asset or liability exists, and when to report such items on the balance sheet.  GAAP already requires arrangements such as capital leases and certain SPEs to be included on the balance sheet of the primary beneficiary of the contracts.  For some specified arrangements where assets and liabilities are not reported on the balance sheet, particularly operating leases, information about future obligations under the contracts must be disclosed in the notes to the financial statements.

Consider unconsolidated equity investments in which an investor owns less than 50 percent, SPEs created for the primary benefit of a company, or other off-balance-sheet entities.  Here the challenge to the accounting profession is to focus on whether consolidation of such entities actually improves users' understanding of a company's financial position and results of operations.  For most equity method investments, consolidation does not change net income or net assets, causing only offsetting changes in the components of those measures.  Consolidating equity method investments currently not consolidated could reduce disclosures about those investments in the notes to the financial statements.  As a broad objective, the FASB and the SEC should guide the profession in requiring on-balance-sheet treatment where it enhances the financial statements, but allowing off-balance-sheet treatment where it provides better information to investors.

²    Typical take-or-pay contracts obligate the purchaser to take and pay for any product that is offered to it or pay a specified amount if it refuses to take the product.  A throughput arrangement involves an agreement to put a specified amount of product per period through a particular facility; for example, an agreement to ship a specified amount of crude oil per period through a particular pipeline (New York Times 2002).

Sources of Authoritative Guidance for Accounting for SPEs

When the idea of SPEs was first conceived in the minds of some bright financial engineers, no definitive accounting guidance existed.  Although specific accounting guidance for innovative business methods of necessity must lag actual practice, the conceptual framework and other general guidelines should help accountants treat innovative practices.  When SPEs began to appear, corporate accountants, auditors, and the SEC could look only to general principles in the authoritative accounting literature regarding the recognition and de-recognition of assets and liabilities, criteria for recognizing asset sales, consolidation of related entities, and more generally to the "entity concept" literature.

From the early 1980s until the mid-1990s, SPEs proliferated in business practice without any specific official guidance from the Financial Accounting Standards Board (FASB).  Until 1996, all specific guidance regarding SPEs came from the FASB's surrogate body, the Emerging Issues Task Force (EITF), formed by the FASB in 1984 to provide timely financial-reporting guidance on matters that the Board may not have addressed or issued authoritative guidance.  As stated on the FASB's web site (FASB 2002a), the composition of the EITF is designed to include persons in a position to be aware of emerging issues before they become widespread and before divergent practices regarding them become entrenched.  Therefore, when the EITF reaches a consensus on an issue, signified by the support of 11 of the 13 voting members, the FASB usually takes that as an indication that no Board action is needed.  Consensus positions of the EITF are considered part of GAAP.  However, lack of consensus is often viewed as an indication that action by the FASB is necessary.

Nine of the 13 voting members of the EITF are affiliated with public accounting firms, with one member from each of the Big 5 firms, and four members from large companies.³  The Chief Accountant of the Securities and Exchange Commission attends EITF meetings regularly as an observer with the right to participate in discussions and present the SEC's views on topics of discussion.  Although the FASB's Director of Research and Technical Activities is the non-voting Chairman of the EITF, there is no overlap between the members of the FASB and the EITF.  Note that the influence of the public accounting sector of the accounting profession is much greater on the EITF (nine of 13 members are currently public accounting practitioners) than it is on the FASB (three of seven full-time members were public accounting practitioners prior to joining the Board).  One might conclude that authoritative guidance provided by the EITF is likely to have more of a public accounting tilt than if it is provided by the FASB.

The first FASB statement that included any direct reference to SPE's was Statement No. 125 (FASB 1996), later replaced by Statement No. 140 (FASB 2000b).  Both of these Statements focus narrowly on issues involving the transfer (sale) of financial assets, primarily securitization and servicing of receivables.  Authoritative guidance for other SPEs has been developed in a rather piecemeal fashion by the EITF.  Exhibit 1 lists in chronological order the major FASB and EITF pronouncements addressing consolidations and SPEs.  The next section of the paper discusses this authoritative guidance.

AUTHORITATIVE GUIDANCE ON CONSOLIDATIONS

Accounting Research Bulletin No. 51

Over the past 40 to 50 years, the accounting profession gradually developed general policies governing the consolidation of financial statements of companies and their controlled subsidiaries and affiliates.  Accounting Research Bulletin (ARB) No. 51 (AICPA 1959) established broad requirements for companies to fully consolidate majority-owned subsidiaries into their financial statements and show the equity of minority-interest shareholders in the consolidated financial statements.  ARB No. 51 also requires the elimination of intercompany balances and transactions between the two entities so that the consolidated statements represent the financial position and results of operations of a single reporting entity.  An important exception in ARB No. 51 that allowed companies to avoid consolidation for "nonhomogeneous" majority-owned subsidiaries was removed in 1987.

SUMMARY AND CONCLUSIONS

After more than 20 years since SPEs appeared on the business scene, there remains a confusing, if not convoluted, set of guidelines regarding the consolidation of SPEs.  Two streams of reasonably understandable guidance exist for leasing transactions (EITF Issue No. 90-15) and for transfers of financial assets through securitizations (FASB Statement No. 140).  Until now, the only authoritative guidance for other types of SPEs, including many of those used by Enron, is the indication by the EITF and SEC that the guidance outlined in EITF Issue No. 90-15 and Topic D-14, which deals specifically with leasing transactions, is "appropriate" for other non-lease-related SPEs.

The bankruptcy of the Enron Corporation associated with its use of sponsored un-consolidated SPEs has brought these financial innovations to the attention of the public and accounting profession.  From our review of the slowly evolving authoritative guidance on the proper GAAP accounting for SPEs, we draw the following conclusions.  Initially, although thinly capitalizated, SPEs designed to monetize assets such as accounts receivable were properly accounted for by applying the traditional definitions of assets, liabilities, and unrelated entities.  These SPEs engage in FASB Statement No. 140-type transactions.  Cash is usually received for the receivables sold to the SPEs, so there is no problem with establishing the value and, hence, the gain or loss on the assets sold.  Although the sponsoring corporation often guarantees the SPEs' debt, the probability of this becoming a liability is small, because the equity capital provided by unrelated investors is sufficient to absorb the losses, which could be measured objectively.  Nonconsolidation is generally appropriate.

Then, SPEs were used for the acquisition or sale and leaseback of plant and equipment.  However, the arrangements companies must make with their lessor SPEs to avoid consolidation under EITF Issue No. 90-15 are not substantially different from arrangements typically made when leasing properties from established financial institutions in terms of the risks assumed by the lessee.  The problem at Enron, as it expanded the role of SPEs, was that even though its SPEs were thinly capitalized and held assets that posed considerable risks, Enron took the limited authoritative pronouncements literally, allowing them to not consolidate the SPEs, even in situations where Enron assumed virtually all of the risks.  See Benston and Hartgraves (2002) for a description and analysis of what Enron did and did not do.

Amerco Inc., the parent company of U-Haul International, itself hauled Big Four accounting firm PricewaterhouseCoopers into federal court in Arizona last week charging that the Big Four accounting firm was to blame for Amerco's dire financial situation. http://www.accountingweb.com/item/97460 

Bob Jensen's threads on PwC lawsuits can be found at http://www.trinity.edu/rjensen/fraud.htm#PwC 

SPEs and Off Balance Sheet Financing Advice from PwC
"U Haul's Parent Citing Faulty Advice Sues Its Old Auditor," Reuters, REUTERS April 22, 2003

Amerco Inc., the parent of U-Haul International, said yesterday that it had sued its former auditor PricewaterhouseCoopers for more than $2.5 billion in damages.

In the suit, Amerco accused PricewaterhouseCoopers of providing financial advice that it said was flawed and led it to the brink of bankruptcy.

The suit, filed on Friday in the Federal District Court for Arizona , contends PricewaterhouseCoopers's advice, coupled with delays in disclosing an error once it was discovered, caused events that put Amerco in "serious jeopardy."

Amerco said the delay forced it to postpone filing financial statements with regulators and put it in danger of being delisted from the Nasdaq stock market. Amerco, which named a new finance chief last week, avoided bankruptcy by reaching an agreement with lenders last month.

"They gave us bad advice for seven straight years," Amerco's general counsel, Gary Klinefelter, said in an interview yesterday. "We're in the business of renting out trucks and trailers, and they're in the business of giving out accounting advice."

A spokesman for PricewaterhouseCoopers, David Nestor, said the lawsuit appeared to be an effort by Amerco's management to shift blame away from itself.

"The primary responsibility for the accuracy of financial statements lies with the company," Mr. Nestor said. "Once it became apparent that there was an error in Amerco's, we worked with them to get their financial statements correct, which is, of course, the important thing."

The dispute centers on financing arrangements known as special purpose entities that Amerco set up in the mid-1990's. These were created to help expand the company's self-storage business without weighing down its balance sheet with debt.

Mr. Klinefelter said the idea for the special purpose entities, a term that has gained notoriety since they played a crucial role in Enron's collapse, came from PricewaterhouseCoopers, which guided the deals.

Amerco said in the lawsuit that it had been assured by PricewaterhouseCoopers that the special purpose entities could be excluded from its financial statements under federal accounting rules. But last year, after the Enron debacle put the spotlight on these arrangements, PricewaterhouseCoopers re-examined the accounting and realized that Amerco's financial statements had to be restated to include those entities, Amerco said.

"ENRON: what happened and what we can learn from it," by George J. Benston and Al L. Hartgraves, Journal of Accounting and Public Policy, 2002, pp. 125-127 
The following are excerpts only.

Abstract

Enron's accounting for its non-consolidated special-purpose entities (SPEs), sales of its own stock and other assets to the SPEs, and mark-ups of investments to fair value substantially inflated its reported revenue, net income, and stockholders' equity, and possibly understated its liabilities.  We delineate six accounting and auditing issues, for which we describe, analyze, and indicate the effect on Enron's financial statements of their complicated structures and transactions.  We next consider the role of Enron's board of directors, audit committee, and outside attorneys and auditors.  From the foregoing, we evaluate the extent to which Enron and Andersen followed the requirements of GAAP and GAAS, from which we draw lessons and conclusions.

The accounting issues

The transactions involving SPEs at Enron, and the related accounting issues are, indeed, very complex.  This section summarizes some of the key transactions and their related accounting effects.  The Powers Report, a 218-page document, provides in great detail a discussion of a selected group of Enron SPEs that have been the central focus of the Enron investigations.  While very much less detailed than the Powers Report, the discussion in the following section (which may seem laborious at times), supplemented with additional material that became available after publication of the Report, should provide the reader with insight into how Enron sought to bend the accounting rules to their advantage.  However, even a cursory review of this section will give the reader a sense of the complex financing structures that Enron used in an attempt to create various financing, tax, and accounting advantages.

Six accounting and auditing issues are of primary importance, since they were used extensively by Enron to manipulate its reported figures: (1) The accounting policy of not consolidating SPEs that appear to have permitted Enron to hide losses and debt from investors.  (2) The accounting treatment of sales of Enron's merchant investments to unconsolidated (though actually controlled) SPEs as if these were arm's length transactions.  (3) Enron's income recognition practice of recording as current income fees for services rendered in future periods and recording revenue from sales of forward contracts, which were, in effect, disguised loans.  (4) Fair-value accounting resulting in restatements of merchant investments that were not based on trustworthy numbers.  (5) Enron's accounting for its stock that was issued to and held by SPEs.  (6) Inadequate disclosure of related party transactions and conflicts of interest, and their costs to stockholders.

2.1.5 Subsequent actions and accounting changes as Enron's stock prices declined

By November 2000, Enron had entered into derivative contracts with the Raptors I, II, and III with a notional value of $1.5 billion on which it had a gain of $500 million.  However, the Raptors' principal asset from which it could pay this amount consisted of Enron stock or obligations, or TNPC stock.  By late March 2001, as the price of Enron's shares declined, the Raptors' credit capacity also declined.  To avoid having to report a $500 million pre-tax charge against earnings, Enron executed a cross-collateralization among the Raptors, "invested" additional Enron stock contracts, and engaged in a series of complex and questionable hedges and swaps with the Raptors.  Based on these moves (which Andersen apparently approved), it was determined that a loss of only $36.6 million had to be recorded for the first quarter of 2001.

In September 2001 Enron terminated the Raptors by buying out LJM2 for approximately $35 million, even though they estimated that their combined assets were approximately $2.5 billion and combined liabilities $3.2 billion.  This resulted in a charge of approximately $710 million after taxes on Enron's third quarter 2001 financial statements.  In all, Enron's not consolidating these SPEs increased its reported earnings as follows ($millions):

Thus, at a very considerable cost to shareholders, Enron's managers temporarily were able to hide substantial loses.

Summary and conclusions

We believe that US GAAP, as structured and administered by the SEC, the FASB, and the AICPA, are substantially responsible for the Enron accounting debacle.  Enron and its outside counsel and auditor felt comfortable in following the specified accounting requirements for consolidation of SPEs.  The SEC had the responsibility and opportunity to change these rules to reflect the known fact that corporations were using this vehicle to keep liabilities off their balance sheets, although the sponsoring corporations were substantially (often almost entirely) liable for the SPEs' obligations.

We also believe that the UK GAAP, which requires auditors to report a "true and fair view" of an enterprises' financial condition is preferable to the highly specified US model.  The US model allows--even encourages--corporate officers to view accounting requirements as if they were specified in a tax code.  For taxes, avoidance of a tax liability by any legally permissible means not only is acceptable, but is an obligation of corporations acting in the interests of their shareholders.  Enron appears to have taken the same approach to accounting (except that what was done was detrimental to its shareholders).  The gatekeepers (Vinson & Elkins and Andersen) seem to have gone along and possibly even participated in this approach to accounting.

The most important lesson with respect to GAAS is that Andersen's partners and staff do not appear to have exercised the requisite skepticism that auditors should adopt.  Rather, they appear to have accepted too readily management's valuations and determinations with respect to valuations and related-party transactions.  It is possible that this presumed lack of skepticism and distance is simply a failing of the particular auditors-in-charge.  Or, it may be a consequence of auditors having been associated with Enron for many years.  (Familiarity may breed over-involvement with and empathy for managements' worldview, rather than contempt.)  Or, the auditors in charge of the Enron audit may have overlooked or supported their client's overly "aggressive" accounting, misleading, and possibly fraudulent accounting practices in order to protect their very salaries and bonuses.¹³  Or, as many critics have charged, the gatekeepers may have been corrupted by the sizeable audit and possibly the non-audit fees paid by Enron.

Andersen's audit personnel also might have been incapable of understanding the complex financial entities and instruments structured by Enron's chief financial officer, Andrew Fastow.  These auditors dealt with Enron when it was an oil and gas producer and distributor.  In recent years, it became primarily a dealer in financial instruments and a developer of new ventures.  For reasons that have yet to be explained, Andersen did not replace these auditors or (apparently) provide them with the requisite expertise.  Another lesson, then, is that CPA firms should ascertain that their personnel are capable of dealing with the presently existing activities of their clients.

Synthetic Leasing

On March 1, 2002 in the wake of the Enron scandal and the FASB wrote a summary report of SPE accounting at http://www.fei.org/download/FASB_SPE.pdf 

Often these structures are used to finance specific assets or a revolving asset base transferred to the SPE. The transfer of trade receivables, loans, or investment securities to the SPE would generally be followed by the SPE’s issuance of debt to investors secured by the transferred assets. The borrower/transferor gains access to a source of funds less expensive than would otherwise be available. This advantage derives from isolating the assets in an entity prohibited from undertaking any other business activity or taking on any additional debt, thereby creating a better security interest in the assets for the lender/investor. SPE financing structures issue many forms of asset-backed securities, including collateralized bond, debt, and loan obligations; and trade receivable commercial paper conduits.

An SPE might be the lessor of a property built for the specific needs of an identified lessee, such as a power plant or a production facility. These transactions are often referred to as synthetic leases and provide tax-advantaged financing lower than traditional mortgage loans. Another form of tax-advantaged SPE transaction is the sale to an SPE of an asset that qualifies as a financing under tax regulations, with any gain on sale deferred for tax purposes. These are known as debt-for-tax transactions.

Topic:
Questions and Answers Related to Derivative Financial Instruments Held or Entered into by a Qualifying Special-Purpose Entity (SPE) --- http://accounting.rutgers.edu/raw/fasb/draft/q&a140_supplement.pdf 

In September 2000, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. The FASB staff determined that the following questions and answers should be issued as an aid to understanding and implementing Statement 140 because of certain inquiries received on specific aspects of that Statement. 

The Board reviewed the following questions and answers in a public meeting and did not object to their issuance. The questions and answers will be included in a future edition of the FASB Staff Implementation

Bob Jensen's threads on derivative financial instruments are at http://www.trinity.edu/rjensen/caseans/000index.htm 

The following SEC quotation is taken from http://www.sec.gov/info/accountants/speechoutline.htm#ragone00 

I. Consolidation of Special Purpose Entities 

A. Factors to consider in determining sponsor of SPE (Ragone, 2000)

The staff has received several inquiries relating to the consolidation of special-purpose entities ("SPEs"). As I discussed at this conference last year, when analyzing these transactions, the staff looks to the guidance contained in EITF Issue 90-15, Impact of Nonsubstantive Lessors, Residual Value Guarantees, and Other Provisions in Leasing Transactions, EITF Topic D-14, Transactions involving Special-Purpose Entities, and EITF Issue 96-21, Implementation Issues in Accounting for Leasing Transactions involving Special-Purpose Entities. The guidance in these EITF Issues discusses when a sponsor or transferor should consolidate an SPE. In many SPE transactions, there are several parties involved, and it may not be clear which party is the sponsor. Recently, the staff was asked for its views on how a registrant should determine who is the sponsor of an SPE.

The staff believes that registrants should not apply any one specific factor to determine the sponsor of an SPE, and believes that all of the facts and circumstances of each transaction should be considered carefully. In this regard, the staff believes registrants should consider the following qualitative and quantitative factors in evaluating who the sponsor is of an SPE:

Qualitative Factors

Purpose. What is the business purpose of the SPE? Name. What is the name of the SPE?

Name. What is the name of the SPE?

Nature. What are the types of operations being performed (for example, lending or financing operations, asset management, and insurance or reinsurance operations)?

Referral Rights. Who has, and what is the nature of, the relationships with third parties that transfer assets to or from the SPE?

Asset Acquisition. Who has the ability to control whether or not asset acquisitions are from the open market or from specific entities?

Continuing Involvement. Who is providing the services necessary for the entity to perform the nature of its operations, and who has the ability to change the service provider (for example, asset management services, liquidity facilities, trust services, financing arrangements)?

Placement of Debt Obligations. Who is the primary arranger of the debt placement, and who performs supporting roles associated with debt placement? 

Quantitative Factors

Residual Economics. Who receives the residual economics of the SPE including all fee arrangements?

Fee Arrangements. Who receives fees for asset management, debt placement, trustee services, referral services, and liquidity/credit enhancement services? How are the fee arrangements structured?

Credit Facilities. Who holds the subordinated interests in the SPE? In summary, the determination of who the sponsor is in SPE transactions requires one to exercise sound professional judgment. The qualitative and quantitative factors discussed above are not intended to be all-inclusive. In analyzing these transactions, registrants should consider and weigh all the factors noted above, among other items particular to the arrangement, before concluding on any given set of facts and circumstances.

You can read the following at http://www.saul.com/services/lease_acc.htm 

EITF 90-15. The Emerging Issues Task Force ("EITF") of FASB has addressed circumstances under which the lessor and the lessee are "consolidated" for financial accounting purposes. Under EITF 90-15, the lessee will not receive off-balance sheet accounting treatment if all of the following tests are met:

Substantially all of the activities of the lessor involve assets that are leased to the lessee.

The lessee bears substantially all of the residual risks and enjoys substantially all of the residual benefits of the leased assets.

The lessor has not made any substantive investment that is at risk during the term of the lease.

The first test of EITF 90-15 is met in a synthetic lease if the transaction is structured using an SPE as the lessor. In addition, the triple-net lease meets the second test. With respect to the third test, however, EITF 90-15 proposes three (3) percent as the minimum equity (now 10% after FASB Interpretation 46 in January 2003) that qualifies as a "substantive" investment with the result that the typical synthetic lease SPE is structured with a three percent equity contribution. When using a special purpose entity, lessee will also be concerned that the transaction is structured to comply with the February 23, 1999 FASB Exposure Draft on Consolidated Financial Statements which suggests very clearly that under certain circumstances a three (3) percent equity contribution may no longer be sufficient by itself to avoid consolidation.

SPEs are focused upon in other FASB Emerging Issues Task Force (EITF) pronouncements.  These are a part of a much larger mosaic of off-balance sheet financing.  Note the following from http://accounting.rutgers.edu/raw/fasb/eitf/bytype.pdf 

Off-balance-sheet financing

84-11 Offsetting installment note receivables and bank debt ("note monetization")

84-15 Grantor trusts consolidation

84-23 Leveraged buyout holding company debt

84-25 Offsetting nonrecourse debt with sales-type or direct financing lease receivables

84-26 Defeasance of special-purpose borrowings

84-30 Sales of loans to special-purpose entities

84-41 Consolidation of subsidiary after instantaneous in-substance defeasance

84-42 Push-down of parent company debt to a subsidiary

85-11 Use of an employee stock ownership plan in a leveraged buyout

85-16 Leveraged leases

86-36 Invasion of a defeasance trust

87-7 Sale of an asset subject to a lease and nonrecourse financing: "wrap lease transactions"

91-10 Accounting for tax increment financing entities and special assessments

01-5 Application of FASB Statement No. 52, Foreign Currency Translation, to an Investment Being Evaluated for Impairment That Will Be Disposed Of

Inventory/fixed assets/leases 

96-20 The Impact of FASB Statement No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, on Consolidation of Special-Purpose Entities

96-21 Implementation Issues in Accounting for Leasing Transactions Involving Special-Purpose Entities

97-1 Implementation Issues in Accounting for Lease Transactions, Including Those involving Special-Purpose Entities

97-6 Application of EITF Issue No. 96-20, "Impact of FASB Statement No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, on Consolidation of Special Purpose Entities," to Qualifying SPEs Receiving Transferred Financial Assets Prior to the Effective Date of Statement 125

"Securitization and Structured Finance: Legitimate Business Management Tools," by Barbara T. Kavanagh, Hosted by the Financial Management Association (FMA) --- http://www.fma.org/FMAOnline/Securitization.pdf 

Introduction

The events and controversy surrounding the bankruptcy of Enron have led many to believe that securitization and structured finance serve no other purpose than deceit and deception. In reality, these are modern business tools that, when properly deployed, allow corporate treasurers to transfer risk, access alternative funding sources and capital markets, and maximally leverage a corporation’s own expertise despite an inevitably limited capital base.

 This article explains the basic components of structured finance transactions and the sound reasons for their undertaking from both an investor and originator perspective, and will also provide the reader with examples of different common structures. Section II of this document describes the basic mechanics and players inherent in nearly all securitizations and structured transactions; the remaining sections of this document will discuss examples of different types of structures. Section III discusses asset backed commercial paper (ABCPs) vehicles and the important reasons for their evolution. Section IV will dissect a project finance securitization, generally undertaken to specifically fund the project(s) in question. Section V will discuss catastrophe linked bonds , or “cats”, as an example of a means of shifting a risk concentration away from the originator and towards investors in need of portfolio diversification.

 Fundamental Components of Securitization and Structured Transactions 

Certain structural features are common across all structured transactions. In each case, a separate entity is created in which a population of assets or cash flows can be isolated. Commonly called a special purpose vehicle or entity (“SPV or SPE”), the SPV then issues debt and/or equity instruments to investors representing claims on the cash flows or assets isolated in the SPV. The SPV is often a trust or corporation whose establishment is in the best interests of both originator and investor. 

A structure can be a “cash flow” or “synthetic” securitization vehicle. In a cash flow-based securitization, the ownership of the assets whose cash flows are to be securitized are actually transferred to the SPV. In a “synthetic” securitization, by contrast, the cash flows and/or economic exposure is transferred to the SPV through the use of a total return swap or some other derivatives transaction. The two are equivalent from a risk and return standpoint, but synthetic SPVs do not assume actual ownership of any assets. 

From the perspective of the originator of a cash flow securitization, isolating the assets or cash flows in question in an SPV is often a necessary step to achieve sales accounting treatment under GAAP and thereby remove the assets in question from its balance sheet. 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. 

Two additional players are almost always present in each structured transactions, one to insure strict adherence to the prescribed terms of the deal, the other to manage funds movement and cash flows. These are the trustee and servicer, respectively. The trustee is an independent third party paid a fee and retained from the onset of the transaction to essentially act as an advocate for the SPVs security holders. The trustee monitors systematic reports by the servicer tracking asset or pool performance, takes in cash flows collected by the servicer, and acts to monitor the entire transaction on behalf of the security holder and in relation to underlying legal indentures. Many structured finance transactions contain prescribed “trigger events”- specifically identified events or performance measurements that, when realized, may cause early liquidation or other actions to preserve the interests of the security holder. It is the obligation of the trustee to track deal performance, based on data provided monthly from the servicer, and take such actions as legal covenants in the structure require to preserve the interests of the SPV’s security holders. Similarly, the trustee will take in cash flows collected and forwarded by the servicer and pass them through to security holders, also as prescribed by terms of the underlying structure and supporting legal documents. 

The servicer in structured transactions is often the originator of the assets in question. By way of example, assume a bank bundles a population of residential mortgages it has originated, conveys them to an SPV, and the SPV then issues securities representing the beneficial interests in the cash flows eminating from those mortgages. Most commonly the originator is also the servicer- in this case a bank. It allows the originator to enjoy fee income over the life of the transaction, and in this case also keeps the bank customer from realizing some party other than the bank has met its credit needs. That is, the mortgage obligor continues making payments to the bank monthly as required; the bank, however, passes them through to the trustee who, in turn, passes them along to the investor holding a security interest in the cash flow stemming from that pool of mortgages. Notably, should the servicer fail to perform as required in the legal documents, the trustee will be required to substitute another servicer so as to preserve the security holder’s interests in the deal. 

Finally, credit enhancements are often indigenous to structured transactions and securitizations (and in many cases, liquidity enhancement as well). Enhancements can be either externally provided by a third party- such as a monoline insurer providing a credit default guarantee- or may be “internal” to the deal. In the latter case, some mechanism(s) is established in the deal design/engineering process to protect security holders from defaults in excess of anticipated levels.

Continued at http://www.fma.org/FMAOnline/Securitization.pdf 

From FEI Express on March 21, 2002

ENRON: AN ACCOUNTING ANALYSIS OF HOW SPEs WERE USED TO CONCEAL DEBT AND AVOID LOSSES  (This research report is not free.)
In this special executive report, Gordon Yale, a forensic accounting expert, examines what not to do with SPEs. His analysis, which looks at elements of the Powers Report, analyzes Enron's use of SPEs, traces the short history of SPE misuse and focuses on controversial gain-on-sale accounting common to many securitizations. Available at the FEI Research Bookstore: http://www.fei.org/rfbookstore/default.cfm 

Enron Auditor Carl Bass Disclosures in 1999

"Andersen auditor questioned Enron:  Carl Bass raised accounting issues with Enron in 1999, documents show." CNNMoney,  April 2, 2002 --- http://money.cnn.com/2002/04/02/news/companies/andersen_bass/ 

Arthur Andersen auditor Carl Bass questioned Enron Corp.'s accounting practices as far back as December 1999, documents released Tuesday by congressional investigators show.

Bass expressed his discomfort in December 18, 1999, with Enron's aggressive hedging strategy for derivatives. In a message to John Stewart, an Andersen partner in Chicago, Bass said he told colleague David Duncan that he objected to using one derivative to hedge another derivative. Duncan was the lead audit partner on the Enron account.

Derivatives cannot hedge derivatives for accounting purposes -- now or under FASB 133," Bass said. "Does Dave [Duncan] think his accounting works even under FASB 133? No way."

Both Bass and Duncan reportedly are in talks with federal prosecutors and their testimony could be used in the obstruction case against Andersen.

Andersen in January fired Duncan for instigating the destruction of Enron Corp. documents. Houston-based Enron allegedly used off-the-book transactions to hide $1 billion in debt and to inflate profits. Enron, once the nation's seventh-largest company, filed the largest bankruptcy in U.S. history last December.

Arthur Andersen, Enron's auditor for 16 years, was hit with a federal indictment March 14 for allegedly obstructing justice when it destroyed Enron documents. Andersen is now near collapse and called off merger negotiations Tuesday with KPMG International. The proposed Andersen-KPMG transaction would have combined the two firms's non-U.S. partnerships.

In a February 1, 2000 e-mail to Stewart, Bass laid out issues he had with a "complicated series of Enron derivatives." Three days later, Bass sent another message stating he was "still bothered" with a partnership, SPE, and believed it to be non-substantive.

Because of such complaints, a senior Enron executive asked Duncan to remove Bass from any review responsibility for the Enron account, the Wall Street Journal reported Tuesday. Bass was removed in 2000, the WSJ said.

Enron's Misuse of SPEs:   The Powers Report

Enron:  Bankruptcy Court Link http://www.nysb.uscourts.gov/ 
The 208 Page February 2, 2002 Special Investigative Committee of the Board of Directors (Power's) Report--- 
Alternative 1:  http://nytimes.com/images/2002/02/03/business/03powers.pdf 
Alternative 2:  http://i.cnn.net/cnn/2002/LAW/02/02/enron.report/powers.report.pdf 
Alternative 3:  Part One | Part Two | Part Three | Part Four

Trinity University students may access this report at J:\courses\acct5341\readings\enron\powers.pdf 

News Reports and Miscellaneous Items

"Web of Details Did Enron In as Warnings Went Unheeded," by Kurt Eichenwald and Diana Henriques," The New York Times, February 10, 2002
The article by Eichenwald and Henriques is the best summary of the 200+ page Powers report that I have seen to date

Andersen's negative response to the above report  --- 
Statement of C. E. Andrews, Global Managing Partner, in response to Enron special committee report February 2, 2002 — The report issued today by Enron’s special committee is troubling on many levels. Nothing more than a self-review, it does not reflect an independently credible assessment of the situation, but instead represents an attempt to insulate the company’s leadership and the Board of Directors from criticism by shifting blame to others. http://www.andersen.com/website.nsf/content/MediaCenterEnronResources!OpenDocument  

Under pressure to set accounting standards for the kinds of special purpose entities that kept debt off Enron's balance sheet, the Financial Accounting Standards Board, in February 2002,  has tentatively decided on an approach and directed its staff to begin writing an exposure draft. http://www.accountingweb.com/item/72237 

I asked a former Chairman of the Financial Accounting Standards Board to provide me with his off-the-wall remembrances of the history of SPEs in the United States.  His reply is shown below.

April 3, 2002 message from Dennis Beresford [dberesfo@TERRY.UGA.EDU] 

One of the things that I find most fascinating about the Enron/Andersen saga is how much inside information is being made public (thanks to our electronic age). Yesterday the House Energy and Commerce Committee released a series of internal Andersen memos showing the dialogue between the executive office accounting experts and the Houston office client service people. While I haven't had a chance to read all 94 pages yet, the memos are reported to show that the executive office experts raised significant questions about Enron's accounting. But the Houston people were able to ignore that advice because Andersen's internal policies required the engagement people to consult but not necessarily to follow the advice they received. As far as I know, all other major accounting firms would require that consultation advice be followed.

You can view and download the 94 pages at: http://energycommerce.house.gov/107/news/04022002_527.htm#docs 

Denny Beresford

April 8 Reply from Kobelsky, Kevin [kobelsky@MARSHALL.USC.EDU] 

Denny, 

Thank you for I'm not sure how far you got through the material, but to help others find their way, I suggest the most salient pages explaining how the SPEs work and the decisions that were made be read in the following order: 1. Enron transaction by Bass 2/1/00 (p.4 of all 95 pages if you download them all-about 2 megs) 2. Enron option by Bass 12/18/99 (p.1,2 of 95) 3. Enron by Bass 3/4/01 #3 "raptor" (p.11-12 of 95) which documents that $100 million in losses was hidden in one transaction. 4. Re: Enron Derivative Transaction by Bass 2/4/00 (p.7 of 95)

Please let me know of other items in there I've missed.

Kevin Kobelsky PhD CA*CISA 
Assistant Professor Leventhal School of Accounting, 
Marshall School of Business 
University of Southern California Accounting Building 125 Los Angeles, CA 90089-0441 
Voice: (213) 740-0657 Fax: (213) 747-2815

April 11, 2002 from Heidemarie Lundblad [lundblad@GTE.NET] 

The problem with these specific SPEs was that they were not truly independent in the sense that even the minimal amount of outside investment required under GAAP was not actually there. Some of it had already been repaid before any transactions took place, some if it was under the control of an Enron related party (Fastow and/or Kopper). Finally, the problem with some of the raptors was that Enron was pretending to hedge fluctuations in its New Power with an SPE that had as its only asset New Power stock.. Tricky to do. 

HL

April 11, 2002 reply from Kobelsky, Kevin [kobelsky@MARSHALL.USC.EDU] 

Heidemarie,

Re: independence, had there been 10% rather than 3% (now 10%), would that have made the transactions OK from a GAAP point of view? It wouldn't have made a bit of difference in terms of what actually happened, since once you accept the hedge as unrelated (whatever the criteria), the only issue left is what level of assets in total are available to cover the derivative liability. Thus, while important, I don't think independence at the heart of the problem, which leads to your second point, and my question, concerning the nature of the assets in the SPE. The fact that it was Enron stock is the issue. While I can reason out from first principles why changes in the value of one's stock shouldn't lead to changes in income and expense, there are exceptions. A current example is the push for the cost of executive stock options to be treated as an expense rather than a capital. So it is not entirely clear. And given the US's emphasis on official pronouncements, they become particularly salient, hence my question to Bob and the list.

Another question: what if Enron had done the same deals using the stock of another firm in the same industry, rather than Enron's stock? Then it would be acceptable? But we would have had the same outcome-the losses would be covered until the other firm's stock tanked, with similar measurement and disclosure, and again, a big disaster.

If we don't identify and address the real problems, we can be sure they will recur.

Best regards,

Kevin

 

FEI's Document of Understanding SPEs

The Financial Executives Institute issued its own explanatory report on SPEs in January 2002 in the wake of the Enron scandal.  It attempts to explain why they are used, how they are used, and the background of standards literature on this topic.  Go to http://www.fei.org/download/SPEIssuesAlert.pdf 

Two excerpts are quoted below:

SPE Usage 
To illustrate how an SPE is commonly used in the financial marketplace, consider the following example of a financial asset securitization. Typically, in these types of transactions the SPE is formed to facilitate the sale of specific financial assets belonging to the sponsor company. The assets are sold to the SPE and could include trade accounts receivable, equity securities, notes receivable, etc. A minimum 3% (now 10%) investment from an independent third-party investor is contributed, representing a legal equity ownership interest in the SPE. The 3% (now 10%) is based on the fair value of the financial assets to be sold. 

In exchange for its investment, the third-party equity investor controls the SPE activities and retains the substantial risks and rewards of its ownership in the SPE assets. For an SPE to be an arms length entity, not consolidated into the sponsor’s financial statement, the third-party investor must bear the risk of its investment. If an investor contributes equity as a note payable to the SPE or secures the investment by a letter of credit, insurance or guarantee, the investment would not be considered ‘at risk’. Once the 3% (now 10%) is established, the SPE then finances the remaining funds to acquire the financial assets from the sponsoring company by issuing debt and/or additional equity to institutional investors or public shareholders. 

As long as the specific qualifications are met, the assets and the corresponding debt and equity of the SPE achieve off-balance sheet treatment with respect to the sponsor’s financial statements. Further, if the SPE has no indebtedness other than the asset-secured loan and routine trade payables, the SPE is unlikely to become insolvent as a result of its activities being limited. Therefore, in financial asset securitizations, SPEs provide the sponsor the ability to legally isolate a group of assets from the sponsor’s bankruptcy risk and to reflect the transfer of financial assets as a sale in its financial statements. 

When SPE assets are protected, SPE credit quality is enhanced. Thus financing costs on debt incurred by the SPE are reduced. For an even lower interest rate paid on the debt, the SPE will obtain credit enhancements in the form of recourse debt, subordinate assignments or guarantees, either from the transferor or other third parties. The reduction of credit risk and the marketability of the SPE equity generally diminishes the cost of the capital to a level below that the sponsor would have achieved on its own. Again, it should be noted that such credit enhancement features typically should not be extended to the 3% (now 10%) equity investor as this investment must be ‘at risk’ in order for the SPE to be eligible for deconsolidation by the transferor. The prior example is one of the many types of transactions that use an SPE. The form of the SPE and the structure of the transaction can be vastly different for SPEs used in off-balance sheet activities and leasing arrangements. 

The First American Title Insurance Company and Commercial Mortgage Insight offer specifics with regard to the synthetic-leasing and commercial-mortgage-backed securities area. With these particular industries, loan underwriters and/or credit rating agencies require borrowing entities to be SPEs. Lenders and agencies often demand that the SPE appoint at least one independent controlling person who is not affiliated with the sponsor company. The SPE's organizational documents provide for a unanimous or significant majority vote or consent of the SPE members to approve any bankruptcy filing or any disposition of assets. Loan documents may have other restrictions regarding M&A activity and commingling assets or contracting with affiliates. 

SPEs can create tax advantages for the transferor. As a pass-through entity, the SPE is not taxed at the entity level. The initial documentation alone could make the SPE an expensive conduit. But given the typical size of the SPE transactions and the benefits of the interest rate reduction plus tax savings, the benefits are likely to outweigh the maintenance costs. 

Existing Accounting Guidance for SPEs 
Accounting for SPEs involves a two-step approach. The first is identification of the SPE sponsor. Owing to the number of parties involved in some SPEs, the sponsor may not be easily determined. In this regard, the staff of the SEC Office of the Chief Accountant refers to following Emerging Issues Task Force (EITF) guidance: 

· EITF Issue 90-15, Impact of Nonsubstantive Lessors, Residual Value Guarantees, and Other Provisions in Leasing Transactions 

· EITF Topic D-14, Transactions involving Special-Purpose Entities 

· EITF Issue 96-21, Implementation Issues in Accounting for Leasing Transactions involving Special-Purpose Entities.

The staff also recommends consideration of the following factors: 

· Name and Purpose . What is the name and business purpose of the SPE? 

· Nature. What are the types of operations performed (for example, lending or financing operations, asset management, and insurance or reinsurance operations)? 

· Referral Rights. Who has, and what is the nature of, the relationships with third parties that transfer assets to or from the SPE? 

· Asset Acquisition. Who has the ability to control whether or not asset acquisitions are from the open market or from specific entities? 

· Continuing Involvement. Who is providing the services necessary for the entity to perform its operations and who has the ability to change the service provider (e.g., asset management services, liquidity facilities, trust services, financing arrangements)? 

· Placement of Debt Obligations. Who is the primary arranger of the debt placement and who performs supporting roles associated with debt placement? 

· Residual Economics. Who receives the residual economics of the SPE including all fee arrangements? · Fee Arrangements. Who receives fees for asset management, debt placement, trustee services, referral services, and liquidity/credit enhancement services? How are the fee arrangements structured? · Credit Facilities. Who holds the subordinated interests in the SPE?

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 eliminates one of the key advantages of creating the SPE. The following provides additional guidance on SPE consolidation:

· Financial Accounting Standards Board (FASB) Statement 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities 

· FASB Statement 94, Consolidation of All Majority-Owned Subsidiaries 

· EITF Issue 96-16, Investor’s Accounting for an Investee When the Investor Has a Majority of the Voting Interest but the Minority Shareholder or Shareholders Have Certain Approval or Veto Rights 

· EITF Issue 97-1, Implementation Issues in Accounting for Lease Transactions, including Those involving Special-Purpose Entities 

· EITF Issue 97-2, Application of FASB Statement No. 94 and APB Opinion No. 16 to Physician Practice Management Entities and Certain Other Entities with Contractual Management Arrangements 

· EITF Issue 98-6, Investor's Accounting for an Investment in a Limited Partnership When the Investor Is the Sole General Partner and the Limited Partners Have Certain Approval or Veto Rights.

The primary consideration in determining consolidation is identifying who maintains control of the SPE. EITF Topic D-14 states that nonconsolidation of SPEs and sales recognition related to SPE transactions are not appropriate by the sponsor when:

· The majority owner of the SPE makes only a nominal capital investment 

· The activities of the SPE are virtually all on the sponsor's or transferor's behalf 

· The substantive risks and rewards of the assets or the debt of the SPE rest directly or indirectly with the sponsor.

If the sponsor is the transferor of the financial assets and the SPE meets the ‘qualifying criteria,’ the sponsor can still avoid consolidation, even if the EITF Topic D-14 and related guidelines are not met. Statement of Financial Accounting Standards (SFAS) 140 details these criteria. SFAS 94 provides primary guidance regarding consolidation principles and focuses on control of the entity. Though the remaining guidance is specific to leasing SPEs, it is consistently used in determining consolidation of all SPE types. 

The following issues should be considered when evaluating the consolidation of SPEs:

· Is the capitalization of the SPE adequate at all levels, particularly when (1) multi-tiered SPE structures are utilized, (2) assets held by the SPE are volatile, and/or (3) derivatives are used? · Does the owner’s interest represent a residual equity interest in legal form? 

· Is the equity holder truly subordinate to the debt holders? · How are profits and losses allocated? Does the equity holder have both upside and downside potential? 

· Is the equity investor an independent third party? · Who has actual control over the management and activities of the SPE? · Are the risks and rewards of ownership retained by the third-party equity investor for the entire term of the SPE?

The following issues should be considered when evaluating the consolidation of SPEs: 

· Is the capitalization of the SPE adequate at all levels, particularly when (1) multi-tiered SPE structures are utilized, (2) assets held by the SPE are volatile, and/or (3) derivatives are used? · Does the owner’s interest represent a residual equity interest in legal form? · Is the equity holder truly subordinate to the debt holders? 

· How are profits and losses allocated? Does the equity holder have both upside and downside potential? · Is the equity investor an independent third party? 

· Who has actual control over the management and activities of the SPE? 

· Are the risks and rewards of ownership retained by the third-party equity investor for the entire term of the SPE?

The staff of the American Institute of Certified Public Accountants (AICPA) has prepared a toolkit for accountants and auditors, titled “Accounting and Auditing for Related Parties and Related Party Transactions.” Though not authoritative, the publication was reviewed by the AICPA Audit and Attest Standards staff and is intended to provide an overview of selected accounting and auditing literature, SEC requirements and best-practice guidance concerning related parties and related party transactions. Specific sections apply to SPEs.

The has a section on Enron's troubled SPEs at http://www.fei.org/download/SPEIssuesAlert.pdf 

The Infamous and Controversial 3 Percent Rule

The decision to set it at 3%  3% (now 10% after FASB Interpretation 46 in January 2003)  is arbitrary, but as Denny Beresford pointed out, there is a rationale for setting it small since most SPEs are intended to be enormous projects (such as a pipeline) in which even 3% (now 10%) is a lot of money.

I think that some outsider equity (e.g., 3% (now 10%) is required to cushion value changes of the SPE's assets agains value changes of the SPE's debt. It is my understanding that the SPE should generally have valued assets (let's call it "skin" for reasons explained below) equal to or greater than the value of the debt. The theory is that debt risk is thereby covered, and off-balance-sheet treatment of special projects is thereby covered --- and there can be theoretical and financing reasons for keeping special projects off the consolidated balance sheet.

In theory, the assets of the SPE should have "skin" in the sense that they are also assets that would appear on the consolidated balance sheet if the SPE was consolidated. For example, if General Electric decided to build a pipeline across Africa, GE could co-sign billions in debt/leases of an SPE. The SPE would then borrow the cash and commence to build the pipeline. The SPE's assets would be cash, land, pipes, etc. These have "skin."

The infamous Enron whistle blower (Ms. Watkins), who sent anonymous letters to CEO Ken Lay and Andersen top brass, pointed out that most of the Enron SPEs set up by CFO Fastow "had no skin." By this she meant that the SPE assets were simply Enron stock certificates instead of being cash, land, pipes, and other assets that would be assets if the SPEs were consolidated. Enron, however, could not book its own common stock as an asset.  You can read Ms. Watkins wording at http://www.trinity.edu/rjensen/fraud.htm#Hoax 

As long as Enron's stock was above $80 per share, the "value" of the stock in the Enron SPEs exceeded the current value of the debt that was secretly being kept off Enron's consolidated balance sheets. However, when Enron's share prices took a nose dive, the current value of the SPEs' debt greatly exceeded the value of the SPEs' Enron shares and everything imploded to Enron's ground zero. Had there be some real "skin" other than Enron's shares to offset the value of the debt, Enron would not have imploded.

Hence, just because a company has SPEs does not mean that there is a high risk of imploding like Enron. The values of the SPEs' "skins" are what you need to investigate to evaluate the real underlying risk.

Enron was just too thin skinned in most of its 3,000+ SPEs.

What may be missing in accounting for an SPE may be the continual monitoring of fair value of real skin that should not fluctuate wildly in value (unlike Enron share values used as skin).

By real skin, I mean hard cash or hard assets like cash, real estate, and construction assets.

You really don't mind if you co-signed your kid's second mortgage on a house as long as the value of the house is much higher than the balance on that note payable. In case of default, you should get most of your money back even if your kid only has 3% (now 10%) invested of his or her own money. This sort of SPE is not so troublesome.

But if you co-sign to pay for your kid's college education, and the kid does poorly and flunks out in the senior year, then you may get nothing in the case of loan default. This sort of SPE should be booked all along as your debt.

Bob (Robert E.) Jensen 
Jesse H. Jones Distinguished Professor of Business 
Trinity University, San Antonio, TX 78212 Voice: (210) 999-7347 Fax: (210) 999-8134 Email: rjensen@trinity.edu  
http://www.trinity.edu/rjensen 

-----Original Message----- 
From: glan@UWINDSOR.CA [mailto:glan@UWINDSOR.CA ] 
Sent: Wednesday, February 13, 2002 9:15 AM 
To: AECM@LISTSERV.LOYOLA.EDU Subject: 
What is the rationale for the 3% (now 10%) rule re SPEs?

Maybe this issue has been raised before and I have missed it. Pardon my ignorance, but I am somewhat unclear about the rationale for the 3% (now 10%) rule. In one of the bookmarks in Bob Jensen's library (the one dealing with SPEs), it is mentioned that "according to the accounting regulation, the company establishing the SPE can contribute the remaining 97% and it still qualifies for off- balance sheet treatment." Why 3% (now 10%) and not say 5% or 25%? What is the logic behind the 3% (now 10%) rule? Can consolidation be avoided even though there is control?

George Lan 
University of Windsor

Murat's Reply to Kevin's Reply on April 11, 2002

Kevin: 

Your questions are excellent and as I read the internal memos of Andersen auditors either they did not dare to ask the question or were mired down in GAAP detail. As I recall, SPEs first started with securitizing receivables (mortgage notes) where an SPE simply buys the receivables and sells to outside investors in bundles then transfers the collections (purchase price) to the transferor. Thus, cash is coming in from an outside entity. In Enron's case there is no cash coming in from outside plus Fastow and company do not have capital to underwrite the risk. Enron is putting the assets their own stock [it would not have mattered if it was some other company's stock or Enron's cash! All Fastow is doing is giving Enron the wiggling room in accounting to get liabilities off balance sheet at a price. When no risk is transferred why is Enron getting into this deal is the question auditors should be asking rather than all the GAAP rules! In my opinion this is fraudulent.

Regards. Murat

Murat N. Tanju Professor of Accounting Phone # 205.934.8822 Fax # 205.975.4429

-----Original Message----- 
From: Kobelsky, Kevin [mailto:kobelsky@MARSHALL.USC.EDU]  
Sent: Thursday, April 11, 2002 12:05 AM 
To: AECM@LISTSERV.LOYOLA.EDU 
Subject: Was Enron's treatment actually in compliance with GAAP? Clarifica tion re criterion for 'skin' in SPEs

Bob and learned colleagues,

On Bob's excellent web page, http://www.trinity.edu/rjensen/fraud021402.htm  he comments, "In theory, the assets of the SPE should have "skin" in the sense that they are also assets that would appear on the consolidated balance sheet if the SPE was consolidated. For example, if General Electric decided to build a pipeline across Africa, GE could co-sign billions in debt/leases of an SPE. The SPE would then borrow the cash and commence to build the pipeline. The SPE's assets would be cash, land, pipes, etc. These have 'skin.' "

This is the only argument I've seen that specifically would indicate that Enron's SPEs were not in compliance with GAAP.

What is the source of this criterion? In the internal Andersen documents, even those written by Bass, this is not mentioned, and I wonder why none of them seemed to be aware of it.

I've been out of financial accounting for a while, but short of this criterion, other arguments that these transactions were not consistent with GAAP from a measurement point of view seem easily contestable (which I'd be glad to discuss), and changes the discussion to a debate about how 'clear' the notes are (e.g., I DO see mention of the $500 million in income impacts in note 16-a big red flag that Watkins mentions on p.7 #6 of her infamous memo to Lay).

Sure, Fastow was a related entity who was enriched to the tune of tens of millions of dollars, but despite the tone of the Board of Directors report, that's small potatoes from a measurement point of view, and a cost of this magnitude certainly would not justify bringing down Andersen, nor would such costs in themselves lead to the failure of Enron. Put another way, Enron would have collapsed just as quickly if an independent party had been doing the deals for huge fees because of the economic structure of the deals.

If the transaction were potentially in compliance with GAAP, we'd be in the unusual situation where the client complied with GAAP in a way that was materially misleading. If this is the case, based on an earlier thread re: the problems auditors have had in withholding opinions in these situations, maybe the profession at large is more culpable than Andersen.

So again, what is the source of this criterion and what basis do we have for holding Andersen to it?

Kevin Kobelsky PhD CA·CISA 
Assistant Professor Leventhal School of Accounting, 
Marshall School of Business 
University of Southern California Accounting Building 125 Los Angeles, CA 90089-0441 Voice: (213) 740-0657 Fax: (213) 747-2815

The source of the now infamous 3 percent asset value rule is EITF 90-15 from the Financial Accounting Standards Board (FASB).  You can read the following at http://www.ahca.org/news/provider/pv9805fn.htm 

The lease must also meet the requirements of FAS 98 and FASB's Emerging Issues Task Force (EITF) 90-15.

FAS 98 relates to properties owned by a company, then sold and leased back. Such sales-leasebacks cannot be set up with a purchase option at the end of the lease term. Therefore, the synthetic lease must be arranged so that the title of the newly acquired property doesn't pass through the hands of the lessor. Ensuring this will allow the company to avoid having to comply with FAS 98.

EITF 90-15 requires that partnerships, special-purpose corporations, or trusts with assets must have equity capital of at least 3 percent of the asset value.

So, if these and, in certain situations, other accounting rules are followed, the lease will meet the technical requirements for operating leases, and the property can be kept off the company's balance sheet.

But because the lessee controls the appreciation of the property and is liable for depreciation, the IRS sees a synthetic lease as a conditional sale, with the lessee entitled to the tax benefits of ownership. So, for accounting purposes the property is owned by the lessor, and for tax purposes the property is owned by the lessee.

The leases may be "more appropriate for public companies," Berman says, although smaller companies planning to go public are also using the product. "It has the most powerful impact for public companies because one of the advantages of the lease is that it removes the depreciation expense of ownership from the company's income statement, so it's an earnings enhancer."

Synthetic Lease Treatment At A Glance
Book And Tax Accounting

 

	Book Accounting	Tax Accounting
Transaction Structure:	Operating lease	Conditional sale
Owner:	Lessor	Lessee
Reason for Classification:	Meets FAS 13	Lessee primarily retains risks and rewards of ownership
Expense Item for Lessee:	Rent	Interest and depreciation

Source: Key Global Finance

Please Help the Financial Accounting Standards Board

This is a great opportunity for practioners to show that they are interested in responding to FASB calls for comments. For example, do you think the new EDs go far enough? How can we get airlines to book billions of dollars in leased airplanes on the balance sheet? These EDs do not seem to do the job.

As influential House Energy Committee Chairman Billy Tauzin called for a review of accounting rules "across the country and across corporate boards," the Financial Accounting Standards Board continued its relentless drive to strengthen the standards. On February 15, FASB announced the release of a revised limited version of an exposure draft entitled Rescission of FASB Statements No. 4, 44, and 64 and Technical Corrections-Amendment of FASB Statement No. 13. The new ED proposes an important change in lease accounting. http://www.accountingweb.com/item/72443 

As influential House Energy Committee Chairman Billy Tauzin called http://quote.bloomberg.com/fgcgi.cgi?ptitle=Securities%20Firms%20News&b1=ad_bottom1&br=blk&tp=ad_topright&T=wealthstory.ht&s=APHASPRYVVGF1emlu  for a review of accounting rules “across the country and across corporate boards,” the Financial Accounting Standards Board (FASB) continued its relentless drive to strengthen the standards. On February 15, 2002, FASB announced http://accounting.rutgers.edu/raw/fasb/news/index.html  the release of a revised limited version of an exposure draft (ED) entitled Rescission of FASB Statements No. 4, 44, and 64 and Technical Corrections-Amendment of FASB Statement No. 13. The new ED supplements a previous ED dated November 15, 2001 and proposes an important change in lease accounting.

Together, the two EDs propose to amend four Statements of Financial Accounting Standards (FAS):

FAS No. 4 - Reporting Gains and Losses from Extinguishment of Debt FAS No. 13 - Accounting for Leases FAS No. 44 - Accounting for Intangible Assets of Motor Carriers FAS No. 64 - Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements

Specific proposed changes include the following:

 

As described in the first ED, companies will no longer be required to classify gains and losses from the extinguishment of debt as extraordinary items, but they will still be allowed to use this accounting treatment in certain circumstances.

 

As described in the new ED, the accounting for certain types of leases will change, (i.e., sale-leaseback transactions and lease modifications with economic effects similar to sale-leaseback transactions).

The reason for two EDs instead of one is because the second has its roots in the comment letters for the first. Commentators suggested changes they felt would improve financial reporting by eliminating inconsistencies in the various standards. FASB agrees in theory. But it also recognizes that some companies might have structured their leases differently, if the proposed accounting changes had been in effect at the time of the transaction. To ensure these substantive changes get a fair hearing, FASB decided to expose them for public comment as part of its “due process.”

Comments on the revised ED http://accounting.rutgers.edu/raw/fasb/draft/rev_ed_rescission.pdf  are due by March 18, 2002.

The item below may help you when you send your letter to the FASB. Perhaps you should complain that the EDs do not go far enough to correct abuses of accounting for synthetic leases.

On February 15, 2002, FASB announced http://accounting.rutgers.edu/raw/fasb/news/index.html  the release of a revised limited version of an exposure draft (ED) entitled Rescission of FASB Statements No. 4, 44, and 64 and Technical Corrections-Amendment of FASB Statement No. 13. The new ED supplements a previous ED dated November 15, 2001 and proposes an important change in lease accounting.  The FASB would like educators and practitioners to respond to these new EDs.

From The Wall Street Journal's Accounting Educators' Reviews on February February 22, 2002

TITLE: Firms Use Synthetic Leases Despite Criticism 
REPORTER: Sheila Muto DATE: Feb 20, 2002 
PAGE: B6 LINK: http://online.wsj.com/article/0,,SB101415738191993240.djm,00.html  

Trinity University students may go to J:\courses\acct5341\readings\WSJsyntheticLeases.htm

TOPICS: Accounting, Creative Accounting, Disclosure, Financial Accounting, Financial Statement Analysis, Lease Accounting

SUMMARY: The article includes a discussion of the features of synthetic leases and the reasons that they are attractive alternatives to purchases and normal lease agreements.

QUESTIONS: 
1.) List the properties of synthetic leases. How are synthetic leases different from "normal" lease agreements? How are synthetic leases different from purchasing assets?

2.) Are synthetic leases accounted for as capital leases or operating leases? Support your answer. In what situations is a lease transaction accounted for as a capital lease? How are the financial statements different if a transaction is accounted for as a capital lease versus an operating lease? In substance, does it appear that a synthetic lease is more similar to a purchase or an operating lease? Support your answer.

3.) What is meant by DuGan when he said, "but synthetic leases have a hidden balloon payment."? Should a balloon payment be recorded on the financial statements? Support your answer.

4.) Should companies be prohibited or discouraged from engaging in synthetic leases? Support your answer. Is better disclosure of synthetic lease transactions needed in financial reporting? What changes in financial reporting are needed to provide better disclosure of synthetic lease transactions?

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

Synthetic leasing is intertwined with special purpose entity ploys to keep debt off the balance sheet. 

"Firms Use Synthetic Leases Despite Widespread Criticism," by Sheila Muto, The Wall Street Journal, February 22, 2002 --- http://online.wsj.com/article/0,,SB101415738191993240.djm,00.html 

The widespread use of so-called synthetic leases by companies to purchase and build everything from new campuses to retail stores is coming under increased scrutiny. But that's not stopping a handful of firms from plowing ahead with the controversial financing method.

A synthetic-lease arrangement allows a company to get the tax benefits associated with owning real estate, while keeping the debt associated with it off its balance sheet. Critics say that such leases are an accounting maneuver that hides potential liabilities and can be used to boost earnings per share.

AOL Time Warner Inc., for one, remains committed to financing the construction of its new Manhattan headquarters at the site of the old New York Coliseum and a new production facility in Atlanta with a $1 billion synthetic lease with Bank of America Corp., according to Michael Colacino of real-estate services firm Julien J. Studley Inc., who worked on the deal for the media giant.

Enron Corp.'s use of off-balance sheet subsidiaries were allegedly used "to conceal lots and lots of debt" and "misdirect people away from understanding" its core business, says Mr. Colacino. In contrast, synthetic leases are "used to finance real estate and equipment that aren't part of the core business of a company." For AOL Time Warner, the synthetic lease is "not a material issue."

A spokeswoman for AOL says a synthetic lease "continues to provide a diversified source of tax advantaged, cost-efficient financing ... our synthetic leases are disclosed in our financial statements, and we believe they are in the best interest of our shareholders."

Cheaper Alternative

In a synthetic-lease deal, a financial institution typically sets up a special-purpose entity that essentially borrows money from the institution to build a facility or purchase an existing one for a company. The special-purpose entity holds the title to the property and leases the property to the respective company. In many cases, the company gets a lower interest rate, which is a floating rate based on the firm's creditworthiness rather than on the value of the real estate, although there are up-front legal and accounting costs. Companies have used synthetic leases to finance equipment purchases as well.

They see them as a cheaper alternative to leasing, purchasing or developing property with traditional loans. For accounting purposes, a company is considered a tenant leasing the property under a synthetic-lease structure. As such, the transaction is treated like a simple operating lease, and the company doesn't have to carry the asset on its balance sheet -- though many companies mention their use in a footnote. That means the company avoids taking depreciation charges against earnings. For tax purposes, the company is considered the owner of the asset. As such, it is entitled to deduct the interest payments and the depreciation of the value of the property.

What's more, typically these lease deals run from three to seven years with options to renew. And that's where potential problems can arise.

Because the leases are short-term, if a company can't renew a synthetic lease because its credit rating has fallen, it may all of a sudden be faced with getting new financing and putting it on its books -- a rude surprise for investors. This might be particularly problematic for companies that are short on cash or have properties whose values have fallen.

"There's nothing wrong with them as a concept," says Gordon DuGan, president of W. P. Carey & Co., a New York-based real-estate investment firm that helps companies get out of synthetic deals, "but synthetic leases have a hidden balloon payment." Given these economic times and the drop in real-estate values in some markets, "you don't want to have to make a payment like that," he says.

Often, these deals lack transparency because the liability a company may have isn't fully divulged. Concern about disclosure prompted an about-face last week by Krispy Kreme Doughnuts Inc., whose previous plan to finance the construction of $35 million manufacturing and distribution plant with a synthetic lease came under fire, touched off by a Forbes magazine story.

The Winston-Salem, N.C., company now says it will finance the facility with a traditional mortgage that will be reflected in its financial statements.

Not Dettered

Other companies, meanwhile, plan to proceed with their plans. In a filing with the Securities and Exchange Commission, Idec Pharmaceuticals Inc. says it plans to develop a new $100 million headquarters campus in the San Diego area and a $300 million to $400 million manufacturing facility in nearby Oceanside, Calif., using "off-balance-sheet lease" arrangements.

Idec Pharmaceuticals Chief Financial Officer Phillip Schneider says that while accountants and lawyers at the San Diego-based biotech company have become "less comfortable" with synthetic leases, "we're still looking at that as an option."

What's more, Mr. Schneider says, "synthetic leases are much lower in cost to the company than a normal lease by about 4%."

Chiron Corp., another biotech company, is proceeding with financing a more than $200 million expansion of its Emeryville, Calif., headquarters, although the deal isn't yet completed, says John Gallagher, a company spokesman.

Mr. Gallagher wouldn't comment on Chiron's reasons for continuing with the synthetic lease deal, but he says the company is "monitoring" reaction to synthetic leases "in light of recent events" involving Enron's off-balance-sheet activity.

From The Wall Street Journal's Accounting Educator Reviews on January 24, 2002

TITLE: Enron Crisis Puts Spotlight on the FASB 
REPORTER: Steve Liesman, Jonathan Weil, Scot Paltrow 
DATE: Jan 18, 2002 
PAGE: C1 
LINK: http://interactive.wsj.com/archive/retrieve.cgi?id=SB1011304091994557880.djm  
TOPICS: Consolidation, Advanced Financial Accounting

SUMMARY: This article relates Enron's accounting woes to the FASB's project on consolidation policy. Enron kept off its books by creating separate entities which were excluded from the consolidated financial statements.

QUESTIONS: 
1.) In the introductory paragraph to the article, the author states that the FASB is debating the critical question of when, not whether, a company should be allowed to keep its debt off its books. Do you think that is an accurate description of what the FASB might be willing to do?

2.) Later in the article, the author makes it clear that the question referred to above is one of "consolidating off-balance debt and assets into the parent company's books." Go to the FASB web site's index of the status of its technical projects ( http://accounting.rutgers.edu/raw/fasb/tech/index.html ). Describe their project entitled Consolidations-Policy and Procedures. In general, when may an entity be excluded from consolidated financial statements? How must such an entity be accounted for? What is meant by the term "special purpose entities"?

3.) One of the criticisms leveled against the FASB in establishing this standard on consolidation policy is that the process is taking much too long. Describe the FASB's due process in establishing accounting standards. How does corporate America influence that process?

4.) Congress also is criticizing the FASB for not standing up to its corporate constituents in areas in which corporations want to avoid providing full disclosures. Yet Congress has in fact threatened the FASB with legislation designed to slow down that process even further. Name two areas in which Congress has represented corporate interests in dealing with the FASB.

5.) "FASB officials also point out not all of Enron's problems were related to its off-balance-sheet debt. Some of [Enron's] financial reporting violated basic accounting principles...indicating that the problem...isn't so much with current standards as it is with compliance." Who is responsible for maintaining compliance with current reporting standards? In general, describe the current system for maintaining compliance with accounting and reporting standards.

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

Bob Jensen's Threads on Accounting, Business, Economic, and Related History
http://www.trinity.edu/rjensen/history.htm 

Please Weep for Captain Harvey Pitt:  Under Either Scenario He's Headed for Heartbreak Hotel

Harvey Pitt was Andersen's lawyer before he heeded the call to public service just a few months ago to become Captain of the USS SEC.  He took command of the ship at a time when the beleaguered Big Five accounting firms had been terrorized by the former USS SEC Captain Osama Levitt and Osama's Chief Accountant Omar Turner.  Before being exiled to Heartbreak Hotel, Osama and Omar inflicted grave damage on the Big Five public accounting firms.  Jeremy Kahn puts it this way:

Captain Pitt took over for Levitt with promises to heal SEC relations with the Big Five by never challenging their fundamental rights of the Big Five to serve management and investors simultaneously with both independent audits of systems that their consulting family helped design and operate through consulting practices.

Indeed, when it turned south,  the USS SEC may have become the Good Ship Lollipop in tropical waters had it not immediately crashed into the Andersen Iceberg following the Enron scandal.  For details of the Enron scandal, see http://www.trinity.edu/rjensen/fraud.htm

Suddenly, Captain Pitt is overseeing a zero-sum game of survival in which he must pick a winning side and a losing side.  Whatever the decision,  powerful forces are going to fling him overboard to join his predecessors in Heartbreak Hotel.

• Scenario 1:  Andersen Gets Hammered by the SEC, and the SEC Sinks SPEs
  
  If the SEC investigation finds the auditing firm severely negligent and in violation of conflict of interest professionalism and he vows to put an end to the evil SPEs, Captain Pitt will be an instant media hero, a beloved Captain who plucked Enron employees and investors out of the thrashing sea and resuscitated  their lives.  But to do so, Captain Pitt must turn on his former Andersen benefactors whom he served so diligently in the past as a lawyer for their firm.  Even worse, when he steps down from the SEC he will be branded with a scarlet letter and banned for ever again being counsel to any public accounting firm or corporation.  In short, media heroes can still end up on the floor of Heartbreak hotel.
  
  
• Scenario 2:  Andersen Gets Whitewashed by the SEC, and the SEC Only Rearranges SPE Deck Chairs
  
  If the SEC investigation finds Andersen's auditors to be noble and independent victims, like the investing public and Enron's employees,  of the dastardly greed of Enron's pirates (Jeff Skilling, Andy Fastow, and Ken Lay), then Captain Pitt will be true to his word and remain adored as a peach of a Captain by public accounting firms.  He might bestow upon them more than they'd hoped for when he took command of the USS SEC.  But his commission will be short lived. The powerful Chairman of the House Energy and Commerce Committee, John Dingell (D-Mich.), will have this peach diced and sliced and then toss the Pitt on the floor of Heartbreak Hotel.  Former Captain Harvey Pitt will be so maligned in the media that he will be blacklisted and possibly disbarred.

Of course there are other scenarios that are less extreme, but it would seem that passions run too high in the Enron scandal.  The Enron collapse ruined the lives of too many people for Harvey Pitt to avoid ending up on the floor of Heartbreak Hotel.  Of course this will greatly please Osama Levitt and Omar Turner in the Heartbreak Hotel.  If he brings along his own Chief Accountant, Bob Herdman, they will at last have four for games of contract bridge.

Harvey Pitt is in for the fight of his life.   In my opinion, SPEs are so important to companies worldwide that the SEC, the FASB, the IASB, and virtually all other standard setters dare not go to battle with industry over SPEs or substitutes, by whatever names, that allow certain types of debt to stay off the balance sheets.

A Message on January 8, 2002 from Dennis Beresford, former Chairman of the Financial Accounting Standards Board

Bob,

In response to Enron, the major accounting firms have developed some new audit "tools" that can be accessed at: http://www.aicpa.org/news/relpty1.htm 

Also, the firms have petitioned the SEC to require some new disclosures relating to special purpose entities and similar matters. The firms' petition is at: http://www.sec.gov/rules/petitions.shtml 

I understand the SEC will probably also tell companies that they need to enhance their MD&A disclosures about special purpose entities.

Denny

Joe Beradino is the CEO of the auditing firm (Andersen, Arthur Andersen, AA) 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.

As the rules stand today, sponsoring companies can keep the assets and liabilities of SPEs off their consolidated financial statements, even though they retain a majority of the related risks and rewards. Basing the accounting rules on a risk/reward concept would give investors more information about the consolidated entity's financial position by having more of the assets and liabilities that are at risk on the balance sheet; certainly more information than disclosure alone could ever provide. The profession has been debating how to account for SPEs for many years. It's time to rethink the rules.

Modernizing our broken financial-reporting model. Enron's collapse, like the dot-com meltdown, is a reminder that our financial-reporting model -- with its emphasis on historical information and a single earnings-per-share number -- is out of date and unresponsive to today's new business models, complex financial structures, and associated business risks. Enron disclosed reams of information, including an eight-page Management's Discussion & Analysis and 16 pages of footnotes in its 2000 annual report. Some analysts studied these, sold short and made profits. But other sophisticated analysts and fund managers have said that, although they were confused, they bought and lost money.

"Enron: A Wake-Up Call,"  by Joe Berardino
The Wall Street Journal, December 4, 2001, Page A18 http://interactive.wsj.com/archive/retrieve.cgi?id=SB1007430606576970600.djm&template=pasted-2001-12-04.tmpl 

I closed my first commentary on this topic with the following quotation at http://www.trinity.edu/rjensen/fraud.htm#Blame 

Quote From a Chief Accountant of the SEC
(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"). People with names like J.P. Morgan, William O. Douglas, Joseph Kennedy, and in our profession, names like Spacek, Haskins, Touche, Andersen, and Montgomery.   But again, improvements can and should be made. First, it has taken too long for some projects to yield results necessary for high quality transparency for investors. For example, in the mid 1970's the Commission asked the FASB to address the issue of whether certain equity instruments like mandatorily redeemable preferred stock, are a liability or equity? Investors are still waiting today for an answer. In 1982, the FASB undertook a project on consolidation. One of my sons who was born that year has since graduated from high school. In the meantime, investors are still waiting for an answer, especially for structures, such as special purpose entities (SPEs) that have been specifically designed with the aid of the accounting profession to reduce transparency to investors. If we in the public sector and investors are to look first to the private sector we should have the right to expect timely resolution of important issues. "The State of Financial Reporting Today: An Unfinished Chapter" Remarks by Lynn E. Turner,   Chief Accountant U.S. Securities & Exchange Commission,  May 31, 2001 --- http://www.sec.gov/news/speech/spch496.htm

 

Enron's auditor, Andersen, blames most of the misleading reporting regarding risk on unconsolidated special purpose entities (SPEs) that only require an outside equity interest of 3% (now 10%) to justify keeping the SPE's assets and liabilities from being consolidated on the parent's balance sheet.  Enron kept entire power plants and millions of debt off the balance sheet with various SPE arrangements.

This begs the question of why SPEs are allowed when the net effect is to possibly mislead investors about risk by keeping huge amounts of debt off the consolidated balance sheet.  In my view, they were created as a ploy to keep debt off the balance sheet when the Financial Accounting Standards Board (FASB) started to get serious about preventing other ploys designed to keep debt off the balance sheet.  Particularly troublesome to companies wanting to keep debt off the balance sheet was FAS 13 that required all financing leases to be booked on the balance sheet, thereby, no longer allowing most financing leases from remaining off the consolidated balance sheet.  

In no way can the above reasoning be published as a justification for SPEs in the official literature.  Hence, it is necessary to look to the official literature for justifications due to securitization and tax advantages.

Bob Jensen's commentary on Joe Beradino's editorial is at http://www.trinity.edu/rjensen/fraud.htm 

"The Big Five Need to Factor in Investors," Business Week, December 24, 2001, Page 32 --- http://www.businessweek.com/ (not free to download for non-subscribers)

At issue are so-called special-purpose entities (SPEs), such as Chewco and JEDI partnerships Enron used to get assets like power plants off its books.  Under standard accounting, a company can spin off assets --- an the related debts --- to an SPE if an outside investor puts up capital worth at least 3% (now 10%) of the SPE's total value.  

Three of Enron's partnerships didn't meet the test --- a fact auditors Arthur Andersen LLP missed.  On Dec. 12, Andersen CEO Joseph F. Berardino told the House Financial Services Committee his accountants erred in calculating one partnership's value.  On others, he says, Enron withheld information from its auditors:  The outside investor put up 3% (now 10%), but Enron cut a side deal to cover half of that with its own cash.  Enron denies it withheld any information.

Does that absolve Andersen?  Hardly.  Auditors are supposed to uncover secret deals, not let them slide.  Critics fear the New Economy emphasis means auditors will do even less probing.

The 3% (now 10%) rule for SPEs is also too lax.

To Andersen's credit, it has long advocated a tighter rule.  But that would crimp the Big Five's clients --- companies and Wall Street.  Accountants have helped stall changes.  

Enron's collapse may finally break that logjam.  Like it or not, the Big Five must accept new rules that give investors a clearer picture of what risks companies run with SPEs.

The rest of the article is on Page 38 of the Business Week Article.

"Arthur Andersen:  How Bad Will It Get?" Business Week, December 24, 2001, pp. 30-32 --- http://www.businessweek.com/ (not free to download for non-subscribers)

QUOTE 1
Berardino, a 51-year-old Andersen lifer, may find the firm's competence in auditing complex financial companies questioned.  While Andersen was its auditory, Enron's managers shoveled debt into partnerships with Enron's own ececs to get it off the balance sheet --- a dubious though legal ploy.  In one case, says Berardino, hoarse from defending the firm on Capitol Hill, Andersen's auditors made an "error in judgment" and should have consolidated the partnership in Enron's overall results.  Regarding another, he says Enron officials did not tell their auditor about a "separate agreement" they had with an outside investor, so the auditor mistakenly let Enron keep the partnership's results separate.  (Enron denies that the auditors were not so informed.)

QUOTE 2
Enron says a special board committee is investgating why management and the board did not learn about this arrangement until October.  Now that Enron has consolidated such set-ups into its financial statements, it had to restate its financial reports from 1997 onward, cutting earnings by nearly $500 million.  Damningly, the company says more than four years' worth of audits and statements approved by Andersen "should not be relied upon."

"Let Auditors Be Auditors," Editorial Page, Business Week, December 24, 2001, Page 96 --- http://www.businessweek.com/ (not free to download for non-subscribers)

But neither proposal (plans proposed by SEC Commission Chairman Harvey L. Pitt) goes far enough.  GAAP, the generally accepted accounting principles, desperately need to be revamped to deal with cash flow and other issues relevant in a fast-moving, high-tech economy.  The whole move to off-balance sheet accounting should be reassessed.  Opaque partnerships that hide assets and debt do not serve the interests of investors.  Under heavy shareholder pressure from the Enron fallout, El Paso Corp. just moved $2 billion in partnership debt onto the balance sheet. Finally, Pitt should consider requiring companies to change their auditors who go easy on them, as we have seen time and time again.

The Big Five Firms Join Hands (in Prayer?)
Facing up to a raft of negative publicity for the accounting profession in light of Big Five firm Andersen's association with failed energy giant Enron, members of all of the Big Five firms joined hands (in prayer?) on December 4, 2001 and vowed to uphold higher standards in the future. http://www.accountingweb.com/item/65518 

The American Institute of Certified Public Accountants released a statement by James G. Castellano, AICPA Chair, and Barry Melancon, AICPA President and CEO, in response to a letter published by the Big Five firms last week that insures the public they will "maintain the confidence of investors." --- http://www.smartpros.com/x32053.xml 

Position of the International Accounting Standards Board --- http://www.iasplus.com/interps/sic012.htm 

Note especially how companies like to use SPEs in leasing situations.

Other justifications are alluded to below.

Embedded Derivatives: Embedded Derivatives in Beneficial Interests Issued by Qualifying Special-Purpose Entities
DIG B12 Statement 133 Implementation Issue

Derivatives Implementation Group   Statement 133 Implementation Issue No. B12 Title: Embedded Derivatives: Embedded Derivatives in Beneficial Interests Issued by Qualifying Special-Purpose Entities   Paragraph references: 12, 60, 61 Date released: October 1999 (Revised Tentative Guidance Released on October 12, 2001) Note: The guidance in this Issue is tentative and may be finalized if an amendment to FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, is issued. The Board intends to issue an Exposure Draft proposing an amendment of Statement 133 in the fourth quarter of 2001. QUESTION If a qualifying special-purpose entity (SPE) under FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, holds a combination of debt or equity securities and derivative instruments, is the investor’s beneficial interest in the qualifying SPE automatically a hybrid instrument that contains an embedded derivative that warrants separate accounting? Specifically, consider the two following examples where the qualifying SPE issues beneficial interests that are accounted for as debt instruments. Example 1 A qualifying SPE holds fixed-rate corporate bonds (7 percent coupon rate) and a pay-fixed (at 7 percent), receive-variable (LIBOR) interest rate swap. An investor purchases a beneficial interest issued by the qualifying SPE that has an interest rate based on LIBOR. Example 2 A qualifying SPE holds EURO-denominated variable-rate corporate bonds and a pay-floating-EURO and receive-fixed-U.S. dollar foreign currency interest rate swap. Assume that the notional amount of the swap matches the principal amount of the corporate bonds, that its repricing dates match those of the bonds, and that the index on which the swap’s variable rate is based matches the index on which the bonds’ variable rate is based. An investor purchases a beneficial interest issued by the qualifying SPE that is denominated in U.S. dollars and has a fixed interest rate. The question of whether a beneficial interest issued by a qualifying SPE is debt or equity is outside the scope of Statement 133. An investor must determine whether the beneficial interest issued by the qualifying SPE that it holds is debt or equity. When the qualifying SPE issues beneficial interests that are accounted for as debt instruments, the following guidance should be applied. For purposes of the above examples, assume that the investor does not consolidate the qualifying SPE. RESPONSE No, the investor’s beneficial interest in the qualifying SPE should not automatically be considered a hybrid instrument that contains an embedded derivative that warrants separate accounting. Statement 133 Implementation Issues No. A20, "Application of Paragraph 6(b) regarding Initial Net Investment," and No. D2, "Applying Statement 133 to Beneficial Interests in Securitized Financial Assets," provides that an investor may conclude that the beneficial interest in the qualifying SPE it holds is a derivative in its entirety because it meets the criteria in paragraph 6 and related paragraphs of Statement 133. If those criteria are not met, then a beneficial interest that is issued by a qualifying SPE must be evaluated under paragraph 12 similar to any other security that may contain terms that affect some or all of the cash flows required by the contract in a manner similar to a derivative instrument. When performing this evaluation, an investor should focus on only the terms and conditions of the beneficial interest and not the detailed holdings of the qualifying SPE. Paragraph 12 requires that an embedded derivative be accounted for separately as a freestanding derivative instrument if the following criteria are met: (a) the economic characteristics of the embedded derivative instrument are not clearly and closely related to the economic characteristics and risks of the host contract, (b) the hybrid instrument is not remeasured at fair value with changes in fair value reported in earnings as they occur, and (c) a separate instrument with the same terms as the embedded derivative instrument would meet the definition of a derivative instrument subject to the requirements of Statement 133. Paragraphs 60 and 61 provide additional guidance for determining when a hybrid instrument contains an embedded derivative that is not clearly and closely related to the host contract. For example, based on the guidance in paragraph 60, if a beneficial interest is accounted for as a debt instrument that is not measured at fair value with changes in value reported in earnings as they occur and incorporates a return that is based on a risk type other than interest rates (such as an equity-based return), the embedded derivative that incorporates the equity-based return would not be clearly and closely related to the host contract and would be required to be accounted for separately. In Example 1, the investor holds a beneficial interest with a payoff equal to a variable-rate bond based on LIBOR, which does not contain an embedded derivative that warrants separate accounting under Statement 133. In Example 2, the investor holds a beneficial interest with a payoff equal to a fixed-rate bond, which does not contain an embedded derivative that warrants separate accounting under Statement 133. If a beneficial interest in a qualifying SPE is not within the scope of Statement 133, the investor should consider the applicability of paragraphs 14 and 362 of Statement 140, which require that retained interests in securitizations in which the holder may not recover substantially all of its recorded investment be subsequently measured like investments in debt securities classified as available-for-sale or trading under FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities. The above response represents a tentative conclusion. The status of the guidance will remain tentative until it is formally cleared by the FASB and incorporated in an FASB staff implementation guide, which is contingent upon an amendment of Statement 133 being issued. The Board intends to issue an Exposure Draft proposing an amendment of Statement 133 in the fourth quarter of 2001. Constituents should send their comments, if any, to Timothy S. Lucas, Derivatives Implementation Group Chairman, FASB, 401 Merritt 7, P.O. Box 5116, Norwalk, CT 06856-5116 (or by e-mail to derivatives@fasb.org by November 16, 2001.

South Africa uses SPEs

Japan also uses SPEs.

Other countries have expressed difficulties with the SPE concept.

A February 15, 2002 Message from Barbara Leonard, Loyola University Chicago [BJBLeonard@AOL.COM] 

Please let me know if I am wrong, but I thought I heard Ms. Watkins say in her testimony that certain contracts to deliver goods or services in the future were sold to the SPEs and then booked the investment in the SPE at fair (market) value, or discounted future cash flows. According to GAAP, Enron would have had to earn, or deliver the product before revenue recognition but simply sidestepped this accounting principle by selling the contract to an investee and then carryied the investee at "fair value." If so, I wonder how many other companies are doing this and why we bother teaching GAAP anyway.

Bob Jensen's Threads on Accounting Fraud, Forensic Accounting, Securities Fraud, and White Collar Crime --- http://www.trinity.edu/rjensen/fraud.htm 

Bob Jensen's Threads on Accounting, Business, Economic, and Related History
http://www.trinity.edu/rjensen/history.htm 

Bob Jensen at Trinity University