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192 STRUCTURED FINANCE AFTER ENRON ad ditional regulatory scrutiny have not been justified, and even if it turns out that Enron did abuse prepaids, that fact alone should not stop other firms from making appropriate use of these products, of which there are many. We urge regulators to move forward with caution, lest a wide range of beneficial activities be penalized for the sins of only one abuser. We also strongly encourage firms not to shy away from these valuable tools for fear of “guilt by Enron association.” With proper attention to struc- turing, disclosure, and accounting, firms using prepaids have nothing for which to apologize. NOTES 1. In cash-settled forwards, the cash payment obligations of the long and short are generally netted into a single payment. 2. To see this, simply imagine that the long in a physically settled forward im- mediately sells the 1,000 bbls of oil on the spot market at the prevailing spot price. The net proceeds from this are identical to a cash-settled contract in which the payment to the long is based directly on the spot price. 3. All of our discussions of “economic equivalence” are meant to apply to the marginal firm in equilibrium. As in many other situations in applied price theory, inframarginal firms may face a different opportunity set in the short run. See the discussion by Culp and Hanke in Chapter 1. 4. This does assume, of course, the usual asset pricing assumptions, including perfect capital markets and symmetric information. 5. As Culp and Miller (1995a) explain, the long cannot escape the cost of phys- ical storage either by synthetically storing with a forward contract. 6. The reason for the significant public information on Mahonia pertains to a lawsuit filed by JP Morgan Chase against the insurance companies that pro- vided Enron with surety bonds to be posted with Mahonia as guarantees of performance on their prepaid contracts. Culp discusses this lawsuit in more detail in Chapter 13. 193 10 ACCOUNTING AND DISCLOSURE ISSUES IN STRUCTURED FINANCE K EITH A. B OCKUS , W. D ANA N ORTHCUT , AND M ARK E. Z MIJEWSKI N ot many people are interested in the debates about the rules that managers must use to prepare a company’s financial statements (generally accepted accounting principles [GAAP]). Most people view those debates as esoteric and irrelevant. Thus, it is no surprise that these debates typically take place only within the confines of the private and governmental regulatory bodies that set the standards for financial reporting. 1 However, because of Enron’s quick loss of billions of dollars of market capitalization and its bankruptcy, these debates gained wide- spread public interest, and accounting rules and their regulation fell into the center of the political arena. 2 Is Enron’s demise an example of the failure of accounting rules? Are the accounting rules inadequate? While we do not have the answers to these questions, in this chapter we contribute to this debate by describing and an- alyzing the accounting rules in the Enron controversy. Specifically, we dis- cuss the accounting rules for consolidation of special purpose entities (SPEs) and how to account for a series of prepaid purchase transactions that are possibly linked or related, which, if treated as one transaction, are the equivalent to a loan (prepaids). On November 8, 2001, less than a month before it declared bankruptcy, Enron announced that it was restating its financial statements because of accounting errors, reflecting its conclusion that three SPEs (Chewco, JEDI, and LJM1) did not meet certain accounting requirements and should have been consolidated (Enron, 2001). The retroactive con solidation resulted 194 STRUCTURED FINANCE AFTER ENRON in a “massive” reduction in Enron’s reported net income and a “massive” increase in its reported debt (Powers et al., 2002). By that time, Enron had also received about $15 billion in cash pre- payments from JP Morgan Chase and Citigroup that were booked against future oil and gas deliveries (see Chapter 9). In certain instances, the cash prepayments and future oil and gas deliveries were apparently booked as a series of transactions through SPE structures. These SPE structures and related transactions now have been alleged to be nothing more than wash trades, where only cash (and no energy) changes hands and thus potentially represented “bank debt in disguise.” In this chapter, we review and discuss how the accounting and disclo- sure of SPEs and related structured finance vehicles are highlighted by the controversy surrounding the failure of Enron. 3 The primary issue with re- spect to consolidation arises when a company’s involvement with an SPE requires it to include the SPE’s assets and liabilities in its consolidated fi- nancial statements. 4 Accordingly, the next section of this chapter summa- rizes the accounting and disclosure of issues pertaining to SPEs. A subsequent section then relates those broad issues to the two alleged abuses of accounting and disclosure policy by Enron. A final section offers a brief summary and concludes with some important public policy lessons. CONSOLIDATION OF SPECIAL PURPOSE ENTITIES In January 2003, the Financial Accounting Standards Board (FASB) is- sued FASB Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51 (FASB, 2003), which is the new guidance re- lated to the consolidation of SPEs. The objective of the interpretation “is not to restrict the use of variable interest entities but to improve financial reporting by enterprises involved with variable interest entities.” Before turning to the current authoritative guidance specific to SPEs leading up to the new FASB interpretation, we first summarize account- ing standards related to the broader topic of consolidation including full consolidation and “one-line” consolidation. These broader standards deal with only the general case of consolidation and do not deal with the spe- cific case of SPE consolidation. Full Consolidation ARB 51 (American Institute of Certified Public Accountants [AICPA], 1959), as amended by FAS 94 (FASB, 1987), provides the primary guid- ance for full consolidation procedures. Fully consolidated financial state- ments represent the financial position and results of operations and cash ACCOUNTING AND DISCLOSURE ISSUES 195 flows for a single entity, although multiple legal entities may be included. All components of the parent’s and subsidiary’s assets, liabilities, rev- enues, expenses, and cash flows are combined. Consolidation must be used in substantially all cases where the parent controls, either directly or indirectly, 50 percent or more of the voting interest of a subsidiary. Con- solidation should not be used when the parent’s control is temporary or significant doubt exists concerning the ability of the parent to control the subsidiary (e.g., the subsidiary is in legal reorganization or bankruptcy). FAS 94 expanded the consolidation rules to include all majority-owned subsidiaries, for example, finance subsidiaries of manufacturing entities that were previously not consolidated. One-Line Consolidation For investments where the parent has significant influence with an entity but not control, APB Opinion No. 18 (AICPA, 1971) requires companies to use the equity method of accounting. Significant influence is gener- ally defined as voting interests between 20 percent and 50 percent. The eq- uity method can be thought of as a one-line consolidation because the investor’s share of earnings from the investment is reported as a single amount in the investor’s income statement. The original investment is recorded at cost as an asset on the balance sheet and is adjusted periodi- cally to recognize the investor’s share of earnings. Components of the in- vestee’s financial statements are not combined with the components of the investor’s financial statements. SPE Consolidation The direct authoritative guidance leading up to FASB’s new interpreta- tion on the consolidation of SPEs has beginnings with accounting for the extinguishment of debt (FAS 76) (FASB, 1983a) and the transfer of receivables with recourse (FAS 77) (FASB, 1983b). FAS 76 provided that debt may be accounted for as extinguished if assets placed in trust out- side the debtor’s control were sufficient to satisfy the debt (i.e., in sub- stance defeasance). FAS 77 permitted the transfer of receivables with recourse to be treated as a sale under certain conditions, including the seller’s surrender of control of the receivables. The provisions of both FAS 76 and FAS 77 were superseded by the FASB in 1996 with the is- suance of FAS 125. Until 1996, all the direct authoritative guidance for SPE consolidation came from the Emerging Issues Task Force (EITF). 5 The first specific ref- erence came from the EITF in 1984 with Issue No. 84-30, Sales of Loans to 196 STRUCTURED FINANCE AFTER ENRON Special Purpose Entities, which addressed the issue of whether the assets and liabilities of an SPE for the purpose of purchasing loans originated by the bank should be consolidated in the bank’s financial statements even though the bank has no equity ownership interest in that SPE (FASB EITF, 1984). The EITF did not reach a consensus on the issue. Consolidation of SPEs was mentioned next at an EITF meeting Feb- ruary 23, 1989, as described in EITF Topic D-14, Transactions Involving Special-Purpose Entities (FASB EITF, 1989). The SEC observer to the EITF raised the issue of whether SPEs should be consolidated and whether asset transfers should be recognized as sales. The SEC observer stated that non- consolidation and sales recognition by the sponsor or transferor are ap- propriate only if the majority owner(s) of the SPE: (1) is an independent third party, (2) has a substantial investment in the SPE, (3) controls the SPE, and (4) has significant risks and rewards of ownership of the SPE’s assets (FASB EITF, 1989). In 1990, the EITF released Issue No. 90-15, The Impact of Nonsubstan- tive Lessors, Residual Value Guarantees, and Other Provisions in Leasing Trans- actions (FASB EITF, 1990). The EITF reached a consensus that a lessee should consolidate an SPE if all of the following three conditions exist in a lease transaction: (1) the SPE’s activities are related to assets to be leased to one lessee; (2) the lessee is expected to have the substantive risks and rewards of the leased assets through such means as the lease agreement, a residual value guarantee, a guarantee of the SPE’s debt, or the option to purchase at a fixed price other than fair value; and (3) the SPE owner(s) had not made a substantive residual equity investment that is at risk during the entire lease term (FASB EITF, 1990). Thus, to avoid consolidation, the transferor of assets to an SPE must avoid these three conditions. Although the EITF issue pertained specifically to leases, these three conditions became the general guidance by analogy for de- termining the consolidation of SPEs. The SEC position with respect to Issue 90-15 was contained in a July 11, 1991, letter from the acting chief accountant of the SEC to the FASB staff (FASB EITF, 1989). The SEC staff indicated that although the three conditions of Issue 90-15 do not apply to nonleasing transac- tions, “they may be useful in evaluating other transactions that involve SPEs.” Also, with respect to the meaning of a “substantive residual equity investment that is at risk” in condition 3, the SEC staff indicated that a working group that was formed with the SEC staff had indicated that an investment of at least 3 percent is substantive (i.e., a minimum accept- able investment). This response was the first quantitative guidance on what constitutes substantive residual equity investment. By analogy, this 3 per- cent guideline appears to have become an absolute standard for the non- consolidation of SPEs in general, including the Enron-related SPEs. ACCOUNTING AND DISCLOSURE ISSUES 197 The first FASB pronouncement to address the SPE issue but only in a limited context was FAS 125, Accounting for Transfers and Servicing of Finan- cial Assets and Extinguishments of Liabilities (FASB, 1996). FAS 125 did not re- place EITF 90-15 and did not address consolidation. It was intended to resolve narrow issues related to the securitization of receivables (see Chap- ter 8) especially related to control. FAS 125 established the conditions for determining when a transfer is accounted for as a sale. FAS 125 also in- troduced the term qualifying SPE (QSPE) to indicate a very limited scope SPE that meets a minimum standard for treating the asset transfer as a sale. FAS 125 did not mention the 3 percent guideline for the outside sub- stantive residual equity investment and did not address consolidation of SPEs. FAS 125 was superseded in 2000 by FAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Debt (FASB, 2000a). Most of the provisions of FAS 125 were carried forward. However, FAS 140 stated that QSPEs “shall not be consolidated in the financial statements of a transferor or its affiliates” (FASB, 2000A, para. 46). To summarize, the guidance in EITF Topic D-14 and EITF Issue 90-15 became the guidance for consolidation of SPEs. The guidance in FAS 140 is narrow in that it does not provide guidance on the consolida- tion of SPEs that are not considered QSPEs. Thus, the guidance in ARB 41, FAS 94, EITF Issue 90-15, Topic D-14, and the SEC staff letter should be applied to SPEs that are not considered QSPEs. FASB Interpretation No. 46 (FIN 46) In January 2003, FASB issued FASB Interpretation No. 46, its new guid- ance on SPEs. In doing so, the Board chose to refer to “variable interest entities” (VIE) rather than SPEs. The board changed the terminology be- cause certain entities commonly referred to as SPEs might not fall under the guidance of FIN 46, while other entities not commonly thought of as SPEs might fall under its guidance. VIEs have one or both of two charac- teristics, the first of which is: 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 inter- ests that will absorb some or all of the expected losses of the entity. In essence a VIE has an insubstantial equity ownership. The Interpreta- tion notes that an equity investment of less than 10% of the entity’s total assets would be insufficient to permit the entity to finance its activities under characteristic 1 above, though a greater percentage of equity own- ership may be necessary. 198 STRUCTURED FINANCE AFTER ENRON The second characteristic of a VIE is: 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 en- tity’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 absorb- ing the expected losses. (FASB 2003) The Interpretation also notes that the equity holders lack the “direct or in- direct ability to make decisions about the entity’s activities through vot- ing rights or similar rights” when the voting rights of certain investors are not proportional to their obligations to accept losses or participate in gains, or when substantially all of the entity’s activities are conducted on behalf of an investor that has relatively few voting rights. This prevents an enterprise from avoiding consolidation of a VIE by organizing it with non- substantive voting interests. An enterprise will consolidate a VIE if that enterprise has claims that “will absorb a majority of the entity’s expected losses, if they occur, re- ceive a majority of the entity’s expected residual returns if they occur, or both.” This test involves a comparison with the enterprises’ claims and obligations to the VIE with those of other parties. The ability to influ- ence the VIE’s results is important, as a “a direct or indirect ability to make decisions that significantly affect the results of the activities of a VIE” is taken as a strong indication that an enterprise should consolidate the VIE. Any entity that consolidates a VIE is referred to as the “primary beneficiary.” When determining whether it should consolidate a VIE, an enterprise is required to “treat variable interests in that same entity held by related parties as its own interests.” For instance, variable interests held by an of- ficer, an employee, or member of the board would be treated as owned by the enterprise for the purposes of the consolidation decision. FASB believes that this Interpretation will “improve comparability between enterprises engaged in similar activities, even if some of those activities are conducted through VIEs.” Further, FASB believes that con- solidation of VIEs will provide more information about the “resources, obligations, risks and opportunities” of the primary beneficiary. It is too early to estimate the extent to which this Interpretation will improve the quality or comparability of financial reporting. ACCOUNTING AND DISCLOSURE ISSUES 199 CONSOLIDATION AND CONTROL AT THE CORE OF ENRON ISSUES As explained in Chapter 8, SPEs are not in and of themselves “guilty” or “innocent.” But firms can use—and, unfortunately, sometimes abuse— accounting and disclosure policies related to SPEs to mislead the users of financial statements. Concealing Debt and Assets Figure 10.1 depicts the Chewco SPE discussed by Kavanagh in Chapter 8. This simple structure illustrates the manner in which Enron allegedly abused accounting and disclosure policies to conceal both asset values and leverage from the market. Recall that the Joint Energy Development Investments ( JEDI) SPE was set up by Enron as a joint venture with the California Public Employee Retirement System (CALPERS) in which each entity had a 50 percent eq- uity interest. In 1997, the estimated value of the assets owned by JEDI stood at $766 million, or $383 million for each partner. Enron felt that CALPERS could be a more effective partner for Enron if its capital were invested in Enron initiatives other than JEDI beginning in 1997. CALPERS, however, did not wish to invest in too many Enron ini- tiatives at the same time. Enron and CALPERS thus sought to sell the CALPERS stake in the JEDI SPE. Lacking a third-party buyer, Enron established Chewco in November 1997. Enron claims that it intended to find an independent third party to capitalize at least $11 million of Chewco—the required 3 percent to cre- ate a “substantive residual equity investment that is at risk” for a firm other than Enron or to satisfy condition 3 of EITF 90-15 for consolida- tion. Nevertheless, no such partner was ever obtained, and Chewco was thus capitalized solely by a nominal investment from one Enron employee, who also acted as the sole managing partner—thus failing to satisfy the nonconsolidation principles of EITF D-14 and 90-15 that required that an independent third party have a substantial investment in the SPE, con- trol of the SPE, and derive significant risks and rewards of ownership of the SPE’s assets. As Figure 10.1 shows, two banks made an unsecured loan to Chewco that was used to buy out CALPERS’ 50 percent interest in JEDI. Because Chewco does not appear to have satisfied the EITF D-14 and 90-15 non- consolidation criteria, Chewco should have been subject to full consolida- tion. Because Enron did not account for Chewco as such, the $383 million in unsecured debt remained off Enron’s books, as did the $383 million in- vestment in JEDI until the restatements in 2001. Also, Enron owned almost 200 STRUCTURED FINANCE AFTER ENRON 100 percent of the equity of JEDI (directly and indirectly through Chewco), but similarly failed to consolidate JEDI in its financial reports. Debt by Any Other Name? Figure 10.2 reproduces Figure 9.4, in which Culp and Kavanagh in Chap- ter 9 present an illustrative structure for how Enron and several of its prominent bankers engaged in prepaid forward and swap contracts. To summarize, the bank entered into a prepaid or made a secured loan to some SPE—for example, Mahonia Ltd. or Delta Energy Corp.—that the SPE used to fund the prepayment on a forward or swap, either physically or cash-settled. The subsequent delivery obligation to the SPE then served as collateral for the SPE to pledge to the bank on the original loan. 6 Sub- sequent physical deliveries by Enron to the SPE and the SPE to the bank created market risk exposure for the bank that was hedged using a cash- settled swap with Enron as counter party. Enron accounted for the cash generated by its prepaid forward sales of energy products (or their cash equivalents in the cases of cash-settled prepaid forwards and swaps) as operating cash flows (as distinct from fi- nancing cash flows or investing cash f lows). In turn, the forward delivery obligation was booked as a price risk management liability, which was the FIGURE 10.1 Chewco SPE CALPERS Enron Bank Bank Joint Energy Development Investments (JEDI) CHEWCO ? 50% of Equity 50% of Equity $383 Million (Unsecured) CALPERS’ Equity Stake in JEDI $383 Million ACCOUNTING AND DISCLOSURE ISSUES 201 balance sheet line item in which Enron reported the unrealized gains or losses from its trading activities. This treatment is consistent with the manner in which Enron booked essentially all of its trading contracts, as Bassett and Storrie explain in Chapter 2. Enron’s accounting treatment of the prepaid forward cash receipts as operating activities did not increase the reported profitability of those activities. However, this accounting treatment did make it appear as if Enron’s (operating) trading activities were generating more cash than it would have appeared if Enron had reported the cash receipts as financing cash flows. This could have led the users of financial state- ments to conclude that Enron was able to turn its trading gains into cash more quickly than they would have absent the prepaid swap transactions. Additionally, the unrealized trading gains that Enron reported were fre- quently based on financial valuation models rather than on market prices (i.e., they were marking to model instead of marking to market); using the prepaid swaps to monetize these unrealized gains could have given the readers of Enron’s financial statements a level of comfort in the FIGURE 10.2 How Enron Engaged in Prepaid Forward and Swap Contracts Bank Enron SPE Prepaid Forwards Secured Loan Cash at Inception Gas at Maturity Cash at Inception Gas at Maturity 1 34 2 Floating Payment Equal to Gas Spot Price Floating Payment at Maturity Tied to Gas Spot Price Sale of Gas Spot after Delivery from SPE Fixed Cash Payment at Maturity Cash-Settled Commodity Swap Sale of Gas on the Spot Market [...]... we simply consider circumstances under which the structure in Figure 10 .2 might collapse into the one shown in Figure 10.3 economically even with a nonconsolidated SPE Before 20 00, there was a body of analogous accounting literature to which an accountant could appeal for guidance in recording a prepaid forward (Turner, 20 02) In 20 00, FASB issued guidance specific to prepaid swaps with Statement 133... Enron in transaction 2 Transaction 3 then cancels out transaction 2 because the same amount of the commodity is returned to Enron Transaction 4 represents the payment the bank receives for returning the commodity to Enron at the thencurrent market price, but this cancels out with transaction 5, or the f loating payment made to Enron in the f loating leg of the swap After transactions 2 and 3 cancel each... Securities and Exchange Commission, asserted that “underlying [FASB’s] 20 4 STRUCTURED FINANCE AFTER ENRON conclusion is that the described transactions are not ‘sham’ transactions but rather swaps with a legitimate business purpose between independent parties who have assumed the risks and rewards of their respective transactions” (Turner, 20 02) Enron’s auditor, Arthur Andersen, put forth a set of four conditions... director of Standard & Poor’s Ratings Service, testified before the Senate: “The effect on Enron’s rating of approximately $4 billion in additional debt-like obligations would have, in all likelihood, significantly altered Standard & Poor’s analysis of Enron’s creditworthiness” (Barone, 20 02) On the other hand, Enron did not use prepaids to generate off-balance-sheet debt; Enron’s liabilities for the prepaid... transactions 1 and 6 as the real economic purpose of the structure ACCOUNTING AND DISCLOSURE ISSUES Cash (Fixed Amount) 20 3 Gas Bank Cash (Floating Price) “Bank Debt” 6 Gas Cash (Fixed Amount) “Cancels” 5 1 Cash (Floating Price) Cash (Fixed Amount) Cash (Floating Price) “Cancels” 2 4 3 Prepaid Forwards Gas Cash (Floating Price) Enron Cash (Fixed Amount) FIGURE 10.3 Gas A “ Wash Trade” Other Issues Independence... management of this risk or the purchaser’s or the purchaser’s other PGA-related economics 4 The purchaser of the gas must have an ordinary business reason for purchasing the gas and not in substance be an SPE established just to effect a secured investment in a debt instrument from a gas supplier (Turner, 20 02) These criteria do not appear directly in the authoritative accounting literature Rather,... is principles based accounting standards According to FASB (20 02) : The main differences between accounting standards developed under a principles -based approach and existing accounting standards are (1) the principles would apply more broadly than under existing standards, thereby providing few, if any, exceptions to the principles and (2) there would be less interpretive and implementation guidance... ACCOUNTING AND DISCLOSURE ISSUES 20 7 management to choose accounting treatments that, in management’s opinion, convey more information, or more reliable information, to the users of accounting reports Applied properly, a principles -based approach is more likely to yield accounting treatments that conform to the substance of the underlying transactions In October 20 02, FASB issued a proposal for principles... GAAP via a private regulatory body (currently the FASB) 2 An example of Congress’s passing laws in reaction to such events is the Foreign Corrupt Practices Act See Chapter 3 for a discussion of the political process that resulted in the passage of this Act 3 We discuss these issues with respect to U.S GAAP 20 8 STRUCTURED FINANCE AFTER ENRON 4 The use of an SPE is just one example of how companies... cross-default provisions or other contract terms, such as termination agreements, have the ability to obtain payments from Enron? Ⅲ Does the SPE have the ability to make the payments if Enron does not? (Turner, 20 02) As in the case of Andersen’s criteria, these indicia are not listed in the authoritative accounting literature but are rather Mr Turner’s view of how to distinguish between prepaid forward contracts . guidance in ARB 41 , FAS 94, EITF Issue 90-15, Topic D- 14, and the SEC staff letter should be applied to SPEs that are not considered QSPEs. FASB Interpretation No. 46 (FIN 46 ) In January 20 03, FASB. affiliates” (FASB, 20 00A, para. 46 ). To summarize, the guidance in EITF Topic D- 14 and EITF Issue 90-15 became the guidance for consolidation of SPEs. The guidance in FAS 140 is narrow in that. FAS 125 did not mention the 3 percent guideline for the outside sub- stantive residual equity investment and did not address consolidation of SPEs. FAS 125 was superseded in 20 00 by FAS 140 , Accounting