Standards
Enron...and After
In the wake of Enron, a new accounting guideline provides special purpose entities with guidance on consolidation principles.
FROM: JAN-FEB 2003 ISSUE | BY STEPHEN SPECTOR
Accounting has traditionally been perceived as a staid, respectable profession — as witnessed by the portrayals of accountants in Monty Python films and others. All that changed last year, and the tidal wave of change can be heralded by a single word — Enron. With Enron, accounting suddenly became sexy — full of intrigue and deception. Although the reasons for the energy trader's collapse are many and varied, one salient fact has emerged. The firm played fast and loose with the way it accounted for its investments in what are called special purpose entities (SPEs).
Responding to demands for more control, the U.S. Financial Accounting Standards Board (FASB) has proposed a number of restrictions to force firms to better report the real relationship between a parent company and its SPEs. Sensitive to the close ties between U.S. and Canadian GAAP, the Accounting Standards Board has also moved to ensure North American enterprises face a level playing field. It issued an exposure draft last year with comments due September 30, 2002. The accounting guideline, Consolidation of Special-Purpose Entities, was intended to provide appropriate guidance for SPEs with respect to the application of the consolidation principles in section 1590 of the Handbook.
What is an SPE?
An SPE is an entity created by an asset transferor or sponsor to carry out a specific purpose, activity or series of transactions. It is established as a limited partnership, limited liability company, trust or corporation, and, thus, may have a limited life. Many companies use SPEs and similar structured financing vehicles to access capital and/or manage risk. The specified purpose of these instruments dictates the level of equity accessed and the degree of risk reduction achieved. Examples of transactions that involve SPEs include the following:
- Leasing arrangements, i.e., sales with leasebacks;
- Financing arrangements with third-party financial institutions to fund acquisitions of assets or businesses; or
- Project development activities.
At the time of the Enron debacle, the U.S. GAAP required a minimum three per cent investment from an independent third-party investor to be contributed in order to represent a legal equity ownership interest in an SPE. The three per cent 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 arm's-length entity and not consolidated into the sponsor's financial statements, the third-party investor must bear the risk of its investment. For example, 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 three per cent 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.
However, many SPEs may be independent in appearance, but not in fact. They actually rely on the financial support of the entity that is the primary beneficiary of the SPE's activities. Although control over the SPE realistically rests with the primary beneficiary rather than with the nominal owner, it has been accounted for as if it were the other way around.
Enron executives used this accounting approach to structure the firm's SPEs so that they were able to keep significant amounts of debt off Enron's balance sheet. The changes implemented by the FASB and the CICA are intended to limit an enterprise's ability to mask its true financial situation in this way.
Intent of the Guideline
The new guideline addresses a weakness in Handbook section 1590; the general principles for determining whether one enterprise consolidates another cannot be applied using the guidance provided.
When the nominal owners of an SPE have not provided sufficient financial support, another party or parties almost always provide that support. The other parties usually protect their interests by placing limits on the SPE's activities or wielding decision-making authority in some form other than a voting interest. In these circumstances, the nominal owners do not in fact control the SPE. Guidance applicable to these circumstances has been set out in the new guideline.
When the nominal owners do not control an SPE, the existence of control is determined by the variable interests in the SPE. Variable interests, which arise from certain contractual rights and obligations or ownership interests, are the means through which an enterprise provides financial support to an SPE and by which it gains or loses from activities and events that affect the SPE's assets and liabilities.
An enterprise (the primary beneficiary) controls an SPE by holding a majority of the variable interests in it or by holding variable interests that are both a significant portion of the total variable interests and significantly larger than any other party's variable interests. And an enterprise that does control an SPE by means of variable interests must consolidate it in its financial statements.
In order to comply with the new guideline, an enterprise that is the primary beneficiary of, or has a significant ownership interest in, an SPE must disclose general information about its relationship with the SPE and the SPE's nature and purpose. An enterprise that is not the primary beneficiary of an SPE, but provides significant administrative services to it, must disclose the SPE's assets and liabilities and its purpose.
At the time of writing, the guideline had yet to be finalized. The guideline will be effective for annual and interim fiscal periods beginning on or after April 1, 2003 — although certain (unstated) requirements would be effective on the issue date. The effect of initially applying the guideline should be reported in the same manner as a change in accounting policy, except that prior years' financial statements are not retroactively restated. Instead, enterprises should provide pro forma disclosure of the effects the guideline would have had on comparative financial statements for prior years.
Remaining Gap in GAAP
The FASB was taken to task for its three per cent threshold and the fact that what was an arbitrary threshold became the rule in practice. Its response was to raise the threshold to 10 per cent. The Handbook guideline does not include a threshold since the notion of a "bright line" test is inconsistent with the underlying requirement that the amount of equity investment be greater than or equal to expected future losses. Further, a benchmark might result in the possibly unwarranted conclusion that the equity investment in an SPE is sufficient to finance the SPE's operations unassisted. Accordingly, the primary beneficiary who controls an SPE by means of variable interests must consolidate it. Full financial disclosure has never been so sexy.
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Stephen Spector, MA, FCGA, owns Spector and Associates and teaches Financial and Managerial Accounting at Simon Fraser University. He also serves on CGA-BC’s board of governors. E-mail shspector@shaw.ca.