A Special Purpose Entity allows “sponsor/originator” companies bearing as much as 90% of the Special Purpose Entity’s debt risk to keep that debt off the consolidated balance sheet under U.S. Generally Accepted Accounting Principals. Although many companies have used SPE’s to hide debt and inflate cash flows, the majority of SPE’s in the world are completely legitimate and serve a vital purpose. Special Purpose Entity accounting arose mostly due to pressures from banks and leasing companies to provide a way to avoid capitalization of special types of leases. Credit enhancements are 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. A synthetic lease is 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 off balance sheet financial reporting of their asset based financing, and that can efficiently use the tax benefits of owning the financed asset. Structured Financing/Transaction is the isolation of assets and obligations in a “structure” apart form the main operations of sponsors. The structure is either referred to as an SPE or SPV (Special Purpose Vehicle. Its 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.
The financial risk of the sponsor of the SPE may be limited to its investment or explicit resource obligation in the SPE. 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.
Enron was able to finance forward sales contracts for energy they would produce for India after their new energy plant was operational using floating rate short-term debt. Once Enron’s new energy plant is operation it’s forward contracts were transferred to an SPE that in turn used these forward contracts as collateral to borrow an enormous amount of cash on fixed rate notes which had rates lower than the entity would be able to obtain on its’ own. Using the sale proceeds to pay off the initial construction loan, Enron would no longer has floating rate interest risk and would retain title to the plant, although the plant itself served as additional collateral to obtain the fixed rate debt.
Some SPE’s 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 crises arises from holding equity shares of sponsors. The fall of Enron could have been delayed or possibly even prevented had their stock price not dropped below $80.00 hitting SPE trigger points. When Enron’s stock price dropped below $80 per share, it allowed the SPEs’ creditors to demand early collections. The Enron shares held by some SPEs could not be sold for sufficient cash t cover the early terminations. Enron became strapped for cash and was unable to cover the triggered obligations with its own corporate cash. Enron’s problem was escalated by its inflated sales values for transferred receivables and by collection difficulties in many of the transferred receivables.
If Enron was successful in achieving its goal according to plan, it would have been able to receive cash for the sale of the forward contracts, and then pay off its short=term, floating rate construction debt with this cash. Once the SPE’s long-term, fexed-rate debt was paid off, the SPE would go out of business and energy sales revenue not needed to service debt or pay off the outside SPE reverts back to Enron. This would have provided Enron with an economic benefit due to being able to obtain lower rate financing, as well as the cosmetic benefit achieved by off balance sheet financing.
Enron’s accounting for its’ non-consolidated special-purpose entities, 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 understated its liabilities. The accounting policy of not consolidating SPEs permitted Enron to hide losses and debt from investors. The accounting treatment of sales for Enron’s merchant investments to unconsolidated SPE’s also aided in misleading investors, creditors and employees alike. Enron’s used an income recognition practice of recording as current income fees for services rendered in future periods and recording revenue from sales of forward contracts, which in essence should have been a liability rather than revenue. Fair-value accounting resulted in restatement of merchant investments that were not based on trustworthy numbers. Enron’s accounting for its’ stock that was issued to and held by the SPE’s also played a large part in its “fraud”.
US GAAP, as structured and administered by the SEC, the FASB, and the AICPA is at least partially responsible for the Enron disaster. 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 liable for the SPE’s obligations. The SEC, FASB and AICPA neglected to do much if anything about the issue and the SEC should have been accountable for their negligence.
