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

Bob Jensen at Trinity University 

Note to my students:
Pay particular attention to the definitions and types of financial structure at http://www.trinity.edu/rjensen//theory/00overview/speOverview.htm#Introduction 
Be able to discuss all definitions and types of structuring, including defeasance and synthetic leasing.  You can read more about synthetic leasing near the bottom of this document.

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).

Enron's very complex, actually unfathomable, SPEs are summarized at http://news.findlaw.com/hdocs/docs/enron/sicreport/chapter1.pdf

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 

From The Wall Street Journal Accounting Weekly Review on May 9, 2008

"FASB Signals Stricter Rules For Banks' Loan Vehicles," by David Reilly,  The Wall Street Journal, May 2, 2008; Page C1 --- http://online.wsj.com/article/SB120969084241961495.html?mod=djem_jiewr_AC

Possible accounting rule changes spurred by the subprime-mortgage crisis would make it harder and costlier for banks to package and sell off loans. That could make borrowing more expensive for consumers and companies but prevent the abuses that led to billions in losses over the past year.

The changes come at a time of scrutiny of how financial institutions packaged mortgages and other loans into securities, shifting the risk of bad loans from their own balance sheets to investors. The changes will "be a little bit like taking the punch bowl away," said Robert Herz, chairman of the Financial Accounting Standards Board, which sets U.S. accounting rules.

Outlining the possible shape of these new rules during an accounting conference Thursday, Mr. Herz indicated that banks might have to keep on their books loans they previously packaged and sold off, or securitized.

Under current rules banks create securitization vehicles that hold the loans off their balance sheets. The Securities and Exchange Commission earlier this year asked the accounting board to create rules for these vehicles by year's end.

The FASB last month tentatively voted to do away with the special securitization vehicles, although it didn't signal how banks would have to account for them. In his remarks, Mr. Herz indicated banks will have to use other rules governing off-balance-sheet vehicles. These rules are likely to be tightened as well.

Any change in the rules surrounding securitization vehicles and other off-balance-sheet entities could have widespread implications for banks. At the end of 2007, J.P. Morgan Chase & Co. and Citigroup Inc. had nearly $1 trillion in assets held off their books in special securitization vehicles. J.P. Morgan generated nearly $3.5 billion in revenue, or about 6% of total 2007 net revenue, from administering special securitization vehicles.

In a statement, Citigroup said, "We are actively engaged in industrywide discussions on the development of the proposal." J.P. Morgan declined to comment.

Mr. Herz didn't push the possibility that banks would be allowed to show the combined effect of these vehicles' assets and liabilities on their books. Such a linked presentation could prevent a ballooning of bank balance sheets. He also said banks likely will face stiffer tests overall for what can stay off their books and may have to take into account emergency-funding arrangements they often offer to off-balance-sheet vehicles.

"Holding back the banks:  Predatory banking practices are likely to continue while political parties are too close to corporations and regulators lack teeth," by Prem Sikka, The Guardian (in the U.K.), February 15, 2008 ---
http://commentisfree.guardian.co.uk/prem_sikka_/2008/02/holding_back_the_banks.html

Politicians and regulators have been slow to wake up to the destructive impact of banks on the rest of society. Their lust for profits and financial engineering has brought us the sub-prime crisis and possibly a recession. Billions of pounds have been wiped off the value of people's savings, pensions and investments.

Despite this, banks are set to make record profits (in the U.K.) and their executives will be collecting bumper salaries and bonuses. These profits are boosted by preying on customers in debt, making exorbitant charges and failing to pass on the benefit of cuts in interest rates. Banks indulge in insider trading, exploit charity laws and have sold suspect payment protection insurance policies. As usual, the annual financial reports published by banks will be opaque and will provide no clues to their antisocial practices.

Some governments are now also waking up to the involvement of banks in organised tax avoidance and evasion. Banks have long been at the heart of the tax avoidance industry. In 2003, the US Senate Permanent Subcommittee on Investigations concluded (pdf) that the development and sale of potentially abusive and illegal tax shelters have become a lucrative business for accounting firms, banks, investment advisory firms and law firms. Banks use clever avoidance schemes, transfer pricing schemes and offshore (pdf) entities, not only to avoid their own taxes but also to help their rich clients do the same.

The role of banks in enabling Enron, the disgraced US energy giant, to avoid taxes worldwide, is well documented (pdf) by the US Senate joint committee on taxation. Enron used complex corporate structures and transactions to avoid taxes in the US and many other countries. The Senate Committee noted (see pages 10 and 107) that some of the complex schemes were devised by Bankers Trust, Chase Manhattan and Deutsche Bank, among others. Another Senate report (pdf) found that resources were also provided by the Salomon Smith Barney unit of Citigroup and JP Morgan Chase & Co.

The involvement of banks is essential as they can front corporate structures and have the resources - actually our savings and pension contributions - to provide finance for the complex layering of transactions. After examining the scale of tax evasion schemes by KPMG, the US Senate committee concluded (pdf) that complex tax avoidance schemes could not have been executed without the active and willing participation of banks. It noted (page 9) that "major banks, such as Deutsche Bank, HVB, UBS, and NatWest, provided purported loans for tens of millions of dollars essential to the orchestrated transactions," and a subsequent report (pdf) (page111) added "which the banks knew were tax motivated, involved little or no credit risk, and facilitated potentially abusive or illegal tax shelters".

The Senate report (pdf) noted (page 112) that Deutsche Bank provided some $10.8bn of credit lines, HVB Bank $2.5bn and UBS provided several billion Swiss francs, to operationalise complex avoidance schemes. NatWest was also a key player and provided about $1bn (see page 72 [pdf]) of credit lines.

Deutsche Bank has been the subject of a US criminal investigation and in 2007 it reached an out-of-court settlement with several wealthy investors, who had been sold aggressive US tax shelters.

Some predatory practices have also been identified in other countries. In 2004, after a six-year investigation, the National Irish Bank was fined £42m for tax evasion. The bank's personnel promoted offshore investment policies as a secure destination for funds that had not been declared to the revenue commissioners. A government report found that almost the entire former senior management at the bank played some role in tax evasion scams. The external auditors, KPMG, and the bank's own audit committee were also found to have played a role in allowing tax evasion.

In the UK, successive governments have shown little interest in mounting an investigation into the role of banks in tax avoidance though some banks have been persuaded to inform authorities of the offshore accounts held by private individuals. No questions have been asked about how banks avoid their taxes and how they lubricate the giant and destructive tax avoidance industry. When asked "if he will commission research on the levels of use of offshore tax havens by UK banks and the economic effects of that use," the chancellor of the exchequer replied: "There are no plans to commission research on the levels of use of offshore tax havens by UK banks and the economic effects of that use."

Continued in article

Jensen Comment
Prem Sikka has written a rather brief but comprehensive summary of many of the bad things banks have been caught doing and in many cases still getting away with. Accounting standards have be complicit in many of these frauds, especially FAS 140 (R) which allowed banks to sell bundles of "securitized" mortgage notes from SPE's (now called VIEs) using borrowed funds that are kept off balance sheet in these entities called SPEs/VIEs. The FASB had in mind that responsible companies (read that banks) would not issue debt in excess of the value of the collateral (e.g., mortgage properties). But FAS 140 (R) fails to allow for the fact that collateral values such as real estate values may be expanding in a huge bubble about to burst and leave the bank customers and possibly the banks themselves owing more than the values of the securities bundles of notes. Add to this the frauds that typically take place in valuing collateral in the first place, and you have FAS 140 (R) allowing companies, notably banks, incurring huge losses on debt that was never booked due to FAS 140 (R).

Also banks are complicit in the "dirty secrets" of credit cards and credit reporting --- http://www.trinity.edu/rjensen/FraudReporting.htm#FICO

Then there are the many illegal temptations which lure in banks such as profitable money laundering and the various departures from ethics discussed above by Prem Sikka.

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

Lessons Not Learned from Enron
Bad SPE Accounting Rules are Still Dogging Us

From The Wall Street Journal Accounting Weekly Review on October 19, 2007

Call to Brave for $100 Billion Rescue by David Reilly The Wall Street Journal Oct 16, 2007 Page: C1 Click here to view the full article on WSJ.com   TOPICS: Advanced Financial Accounting, Securitization SUMMARY: This article addresses a proposed bailout plan for $100 billion of commercial paper to maintain liquidity in credit markets that have faced turmoil since July 2007, and the fact that this bailout "...raises two crucial questions: Why didn't investors see the problems coming? And how could they have happened in the first place?" The author emphasizes that post-Enron accounting rules "...were supposed to prevent companies from burying risks in off-balance sheet vehicles." He argues that the new rules still allow for some off-balance sheet entities and that "...the new rules in some ways made it even harder for investors to figure out what was going on." CLASSROOM APPLICATION: The bailout plan is a response to risks and losses associated with special purpose entities (SPEs) that qualified for non-consolidation under Statement of Financial Accounting Standards 140, Accounting for Transfers and Servicing of financial Assets and Extinguishments of Liabilities, and Financial Interpretation (FIN) 46(R), Consolidation of Variable Interest Entities. QUESTIONS:  1.) Summarize the plan to guarantee liquidity in commercial paper markets as described in the related article. In your answer, define the term structured investment vehicles (SIVs). 2.) The author writes that SIVs "...don't get recorded on banks books...." What does this mean? Present your answer in terms of treatment of qualifying special purpose entities (SPEs) under Statement of Financial Accounting Standards 140, Accounting for Transfers and Servicing Financial Assets and Extinguishments of Liabilities. 3.) The author argues that current accounting standards make it difficult for investors to figure out what was going on in markets that now need bailing out. Explain this argument. In your answer, comment on the quotations from Citigroup's financial statements as provided in the article. 4.) How might reliance on "principles-based" versus "rules-based" accounting standards contribute to solving the reporting dilemmas described in this article? 5.) How might the use of more "principles-based standards" potentially add more "fuel to the fire" of problems associated with these special purpose entities?   Reviewed By: Judy Beckman, University of Rhode Island   RELATED ARTICLES:  Call to Brave to $100 Billion Rescue: Banks Seek Investors for Fund to Shore Up Commercial Paper by Carrick Mollenkamp, Deborah Solomon and Craig Karmin The Wall Street Journal Oct 16, 2007 Page: C1 Plan to Save Banks Depends on Cooperation of Investors by David Reilly The Wall Street Journal Oct 15, 2007 Page: C1

Bob Jensen's threads on accounting theory are at http://www.trinity.edu/rjensen/theory01.htm

"The Accounting Cycle:  FASB Needs to Change Accounting for SPEs," by: J. Edward Ketz, SmartPros, January 2008 --- http://accounting.smartpros.com/x60543.xml

The CDO imbroglio that has enveloped the financial sector created quite a stir in 2007. Mortgage foreclosures have led to losses for the banks, and investors in CDOs have been surprised by the degree of their risk exposure. "Super seniors" have not been super or senior.

Amid this disarray, a simple question has to be asked: why are the activities and transactions of special purpose entities (SPEs), legal entities that run collateralized debt obligations (CDOs) and similar financial vehicles, not displayed on the financial reports of corporate America? These SPEs remain hidden from view and corporate disclosures about them mist like a Chicago fog.

Recall that Enron's episodes were sprinkled with many an SPE shenanigan. The old accounting rule said that if the SPE had at least 3 percent of its total capital from some outside source, then the business enterprise did not have to consolidate the SPE with its own affairs. While EITF 90-15 originally applied to certain leasing activities, business managers quickly applied it to all sorts of SPEs, and the Financial Accounting Standards Board and the Securities and Exchange Commission allowed them to do so. The threshold was so low that managers found it easy to keep SPE debt off the balance sheet and to make few disclosures.

Because of Enron, FASB finally updated the rules to require consolidation unless outsiders contributed at least 10 percent of the capital to the SPE and this capital is at risk. Funny, FASB sat on its collective backside for over a decade before it took action. It seems the board members are incapable of taking proactive steps in any area.

One of the criticisms was that 3 percent equity does not really put the equity at risk. While the 10 percent cutoff remains arbitrary, it clarifies the situation -- until the board muddied this clarity with some mystical, principles-based goobledy-gook. Many managers complained because they perceived that billions of dollars would be added to the corporate balance sheet. Apparently the appeals had some effect, for FASB modified the final rule. Interpretation No. 46R now states:

9. An equity investment at risk of less than 10 percent of the entity's total assets shall not be considered sufficient to permit the entity to finance its activities without subordinated financial support in addition to the equity investment unless the equity investment can be demonstrated to be sufficient. The demonstration that equity is sufficient may be based on either qualitative analysis or quantitative analysis or a combination of both. Qualitative assessments, including but not limited to the qualitative assessments described in paragraphs 9(a) and 9(b), will in some cases be conclusive in determining that the entity's equity at risk is sufficient. If, after diligent effort, a reasonable conclusion about the sufficiency of the entity's equity at risk cannot be reached based solely on qualitative considerations, the quantitative analyses implied by paragraph 9(c) should be made. In instances in which neither a qualitative assessment nor a quantitative assessment, taken alone, is conclusive, the determination of whether the equity at risk is sufficient shall be based on a combination of qualitative and quantitative analyses.

a. The entity has demonstrated that it can finance its activities without additional subordinated financial support.

b. The entity has at least as much equity invested as other entities that hold only similar assets of similar quality in similar amounts and operate with no additional subordinated financial support.

c. The amount of equity invested in the entity exceeds the estimate of the entity's expected losses based on reasonable quantitative evidence.

Note that the 10 percent threshold can be ignored under several scenarios using either quantitative or qualitative excuses. As I said in 2003, this rule or standard is suspect and board members are spineless. The debt of an SPE is similar to the debt of a subsidiary. If FASB thinks that SPE debt does not have to be consolidated, it might as well announce that parent companies no longer have to show the liabilities of their subsidiaries.

We can forget substance over form. While we are at it, we might as well toss out decision usefulness and relevance because FASB really doesn't promote these ideals, despite the rhetoric in the so-called conceptual framework.

Given the ethical failures of both managers and auditors, I predicted in Hidden Financial Risk (2003) that many SPEs would remain unconsolidated. Indeed the majority of SPEs not only remain unconsolidated, but also the sponsoring organizations provide precious little disclosures about them. With the help of investment bankers, corporate managers have been highly creative in finding rhetoric that skirts principled accounting. When the corporate executives are managers of the investment banks, well, the creativity is off the charts.

Years ago FASB and the SEC should have required the consolidation of SPEs. The last six months or so have clearly displayed the need for improved corporate reporting. This directive applies to the sponsors of CDOs including Citicorp and Merrill Lynch: they should consolidate their special purpose vehicles.

How many more debacles in the market place will occur before FASB and the SEC get it right? When will they have men and women of courage?

Bob Jensen's threads on CDO failed accounting (as unbooked debt that won't go away) are at http://www.trinity.edu/rjensen/Theory01.htm#CDO

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

Frank Partnoy's Testimony on Enron's Derivative Financial Instruments Frauds

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.

In the simplest of terms a SPE is an entity that operates like its own separate fund or business apart from its main beneficiary like Enron that created it.  Unlike typical subsidiary corporations, SPEs do not have to be consolidated in the financial statements of the beneficiary. 

The SEC is the accounting standard setter that first allowed SPE accounting off the books.  The main reason is that this allows certain types of ventures that might not otherwise be entered into in cases where the ventures make economic sense.  The key theoretical condition of an SPE is that the current liquidation value of its assets should exceed its debt.  The idea is that nobody gets hurt badly if the SPE is liquidated. 

A very confusing requirement was imposed that an outside investor (independent of the beneficiary) must put up at least 3% of the value of the SPE, thereby cushioning the blow if an SPE is liquidated somewhat below its debt obligations.  After the Enron fiasco, the FASB accounting standard setter raised this limit to 10% but did not go so far as to ban off-book SPE entities.  Entire industries were formed because the SEC allowed SPEs to keep debt off the books, especially the entire industry of synthetic leasing.  Harsher actions by the SEC or the FASB would destroy these entire industries.

The abuse of SPEs arises when the assets of the SPE are not genuine assets, not sufficiently liquid, and/or are overvalued relative to debt obligations.  Having volatile financial instruments and/or derivative financial instruments may be problematic as assets if they are subject to huge value fluctuations in the markets.  Andy Fastow violated the SPE rules by having Enron (in a complicated way) becoming its own sham "outside" investor and in having Enron's own common stock as the main asset of Enron's SPEs hedging its own stock value.

Enron's very complex, actually unfathomable, SPEs are summarized at http://news.findlaw.com/hdocs/docs/enron/sicreport/chapter1.pdf

Also see Bob Jensen's Enron Quiz (and Answers) at http://www.trinity.edu/rjensen/FraudEnronQuiz.htm

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.

SEC Staff Report on Off-Balance Sheet Arrangements, Special Purpose Entities, and Related Issues

From IASPlus, February 16, 2006 --- http://www.iasplus.com/index.htm

The US Financial Accounting Standards Board has submitted its response to the SEC Staff Report on Off-Balance Sheet Arrangements, Special Purpose Entities, and Related Issues released by the US Securities and Exchange Commission in June 2005. The SEC report was prepared pursuant to the Sarbanes-Oxley Act of 2002 and was submitted to the President and several Congressional committees. The SEC staff report includes an analysis of the filings of issuers as well as an analysis of pertinent US generally accepted accounting principles and Commission disclosure rules. The report contains several recommendations for potentially sweeping changes in current accounting and reporting requirements for pensions, leases, financial instruments, and consolidation:

Pensions: The staff recommends the accounting guidance for defined-benefit pension plans and other post-retirement benefit plans be reconsidered. The trusts that administer these plans are currently exempt from consolidation by the issuers that sponsor them, effectively resulting in the netting of assets and liabilities in the balance sheet. In addition, issuers have the option to delay recognition of certain gains and losses related to the retirement obligations and the assets used to fund these obligations.   Leases: The staff recommends that the accounting guidance for leases be reconsidered. The current accounting for leases takes an 'all or nothing' approach to recognizing leases on the balance sheet. This results in a clustering of lease arrangements such that their terms approach, but do not cross, the 'bright lines' in the accounting guidance that would require a liability to be recognized. As a consequence, arrangements with similar economic outcomes are accounted for very differently.   Financial instruments: The staff recommends the continued exploration of the feasibility of reporting all financial instruments at fair value.   Consolidation: The staff recommends that the Financial Accounting Standards Board continue its work on the accounting guidance that determines whether an issuer would consolidate other entities – including SPEs – in which the issuer has an ownership or other interest.   Disclosures: The staff believes that, in general, certain disclosures in the filings of issuers could be better organized and integrated.

FASB's response discusses a number of "fundamental structural, institutional, cultural, and behavioral forces" that it believes cause complexity and impede transparent financial reporting. FASB provides an update on its activities and projects intended to address and improve outdated, overly complex accounting standards. These areas include accounting for leases; accounting for pensions and other post employment benefits; consolidation policies; accounting for financial instruments; accounting for intangible assets; and conceptual and disclosure frameworks. The FASB also identifies several other initiatives aimed at improving the understandability, consistency, and overall usability of existing accounting literature, through codification, by attempting to stem the proliferation of new pronouncements emanating from multiple sources, and by developing new standards in a 'principles-based' or 'objectives-oriented' approach. Click to download:

• February 2006: FASB Response to the SEC (PDF 48k)
• February 2006: FASB News Release (PDF 78k)
• June 2005: Full Text of SEC Staff Report (PDF 1,241k)
• June 2005: SEC Press Release (PDF 40k)
• June 2005: FASB News Release (PDF 14k)

Bob Jensen's threads on off-balance sheet financing are at
http://www.trinity.edu/rjensen//theory/00overview/theory01.htm

FIN 46 

Update on the Infamous Special Purpose Entities (remember Andy Fastow's 3,000+ offshore SPEs for Enron)

FIN 46 made companies admit paternity of SPEs (now called Variable Interest Entities by the FASB).  But it also resulted in some surprise adoptions of SPEs/VIEs.  

Lessons Not Learned from Enron
Bad SPE Accounting Rules are Still Dogging Us

From The Wall Street Journal Accounting Weekly Review on October 19, 2007

Call to Brave for $100 Billion Rescue by David Reilly The Wall Street Journal Oct 16, 2007 Page: C1 Click here to view the full article on WSJ.com   TOPICS: Advanced Financial Accounting, Securitization SUMMARY: This article addresses a proposed bailout plan for $100 billion of commercial paper to maintain liquidity in credit markets that have faced turmoil since July 2007, and the fact that this bailout "...raises two crucial questions: Why didn't investors see the problems coming? And how could they have happened in the first place?" The author emphasizes that post-Enron accounting rules "...were supposed to prevent companies from burying risks in off-balance sheet vehicles." He argues that the new rules still allow for some off-balance sheet entities and that "...the new rules in some ways made it even harder for investors to figure out what was going on." CLASSROOM APPLICATION: The bailout plan is a response to risks and losses associated with special purpose entities (SPEs) that qualified for non-consolidation under Statement of Financial Accounting Standards 140, Accounting for Transfers and Servicing of financial Assets and Extinguishments of Liabilities, and Financial Interpretation (FIN) 46(R), Consolidation of Variable Interest Entities. QUESTIONS:  1.) Summarize the plan to guarantee liquidity in commercial paper markets as described in the related article. In your answer, define the term structured investment vehicles (SIVs). 2.) The author writes that SIVs "...don't get recorded on banks books...." What does this mean? Present your answer in terms of treatment of qualifying special purpose entities (SPEs) under Statement of Financial Accounting Standards 140, Accounting for Transfers and Servicing Financial Assets and Extinguishments of Liabilities. 3.) The author argues that current accounting standards make it difficult for investors to figure out what was going on in markets that now need bailing out. Explain this argument. In your answer, comment on the quotations from Citigroup's financial statements as provided in the article. 4.) How might reliance on "principles-based" versus "rules-based" accounting standards contribute to solving the reporting dilemmas described in this article? 5.) How might the use of more "principles-based standards" potentially add more "fuel to the fire" of problems associated with these special purpose entities?   Reviewed By: Judy Beckman, University of Rhode Island   RELATED ARTICLES:  Call to Brave to $100 Billion Rescue: Banks Seek Investors for Fund to Shore Up Commercial Paper by Carrick Mollenkamp, Deborah Solomon and Craig Karmin The Wall Street Journal Oct 16, 2007 Page: C1 Plan to Save Banks Depends on Cooperation of Investors by David Reilly The Wall Street Journal Oct 15, 2007 Page: C1

Bob Jensen's threads on accounting theory are at http://www.trinity.edu/rjensen/theory01.htm

"All in the Family," by Tim Reason, CFO Magazine, September 2004, pp. 99-100 --- http://www.cfo.com/article.cfm/3126336/c_3148382 

Early in his tenure as chairman of the Financial Accounting Standards Board, while the Enron scandal was raging, Robert Herz was confronted on Capitol Hill by a senator from the South. As Herz tells it, imitating the lawmaker's distinctive drawl, the senator demanded to know when FASB was going to "outlaw the use of these dummy co-poh-ray-shuns."

Clearly, the senator had no use for Wall Street's preferred term, special purpose entities (SPEs). And he had a point: Corporate America was indeed lousy with paper companies that no one seemed to own. Enron, it had just been discovered, had used SPEs to avoid taxes and hide mountains of debt. But how could regulators distinguish those from the vehicles routinely used on Wall Street?

Herz's solution was FASB Interpretation No. 46 (FIN 46), an economic test designed to fill in when legal definitions of ownership fail. The crux of the test: who stands to gain or lose the most from an SPE whose ownership is otherwise unclear? (Such SPEs are now dubbed variable interest entities, or VIEs.) Whichever company proves to be the VIE's "primary beneficiary," said FASB, must consolidate the entity's financial data in its own statements.

Since it was first issued in January 2003, FIN 46 has dramatically reduced the number of orphaned entities. But recently it has also resulted in a few adoptions that FASB never saw coming — at least officially. As a result, some CFOs have found themselves saddled with unwelcome new responsibilities of corporate parenthood.

No More Make-Believe Before FIN 46, the orphan status of SPEs was a large part of what made them so useful. Generally speaking, SPEs are dummy corporations, created to own assets that a company doesn't want on its own books for any of a variety of reasons. For example, for securitization purposes, an SPE increases the value of the assets as collateral by sheltering them from the company's creditors. As long as their "sponsor" company didn't have voting control or too large an equity stake, SPEs were considered independent.

As it turned out, Enron broke even those rules. But in the post-Enron environment, even SPEs long considered legitimate smelled bad to investors. Whatever the stated reason for doing so, keeping assets and liabilities off the balance sheet was hardly transparent.

Today, FIN 46 seems to be having the desired effect. Although no comprehensive impact study has been done, a sample of 300 quarterly reports reviewed by CFO shows that companies are now claiming ownership of many assets and liabilities that common sense has long said belong to them. And apart from the banking industry, which went through a torturous restructuring rather than put billions in securitized assets on bank balance sheets, most companies have quietly accepted the change.