The Evolving Accounting Standards for Special Purpose Entities and Consolidations

INTRODUCTION This paper reviews the major actions taken by the accounting standard setters--the Financial Accounting Standards Board (FASB) and its Emerging Issues Task Force (EITF)--in connection with special purpose entities (SPEs) and traces the evolution of related authoritative guidance. Accounting for SPEs entered public and professional prominence as a result of the Enron Corporation's failure. The primary accounting issues regarding these entities are (1) whether they should be consolidated into the sponsor's (1) (or primary beneficiary's) financial statements or left "off-balance sheet," and (2) whether the sponsor should be able to treat gains and losses resulting from transactions with SPEs as independent, arm's-length transactions. Critics harshly criticized Enron's auditor, Arthur Andersen, for allowing Enron to exclude from its financial statements the SPEs it sponsored, thereby keeping a substantial amount of debt off its balance sheet and recognizing substantially higher profits from transactions with SPEs . We believe it is useful, therefore, to review both the authoritative guidance for the general area of consolidation of financial statements as well as guidance specific to SPEs. This review also provides insight into how standard setting leading to changes in GAAP responds to changes in business practice, and how it might have been more effective in helping to prevent abuses in accounting for SPEs, such as those that ostensibly led to or exacerbated the downfall of Enron (Powers et al. 2002). WHAT ARE SPECIAL PURPOSE ENTITIES? Until recently, many people in the accounting profession, including accounting educators, never heard of SPEs. Some who heard of these esoteric financing vehicles knew little about how they operated or the accounting standards that guide the accounting and financial reporting by companies who sponsor SPEs. Reports in the popular press that preceded Enron's Chapter 11 filing in December 2001 introduced many accountants for the first time to the topic of SPEs and sent many CPAs scrambling to understand the generally accepted accounting principles (GAAP) dealing with these entities. Even though SPE financing vehicles have been around for about two decades, they failed to capture the attention of many participants in the mainstream of accounting discourse. A search for references to SPEs in financial accounting textbooks yields virtually no results, and a search of the academic and professional accounting literature provides, at best, a limited explanation of this area of accounting. Also called special purpose vehicles, SPEs typically are defined as entities created for a limited purpose, with a limited life and limited activities, and designed to benefit a single company. They may take the legal form of a partnership, corporation, trust, or joint venture. SPEs began appearing in the portfolio of financing vehicles that investment banks and financial institutions offered their business customers in the late 1970s to early 1980s, primarily to help banks and other companies monetize, through off-balance-sheet securitizations, the substantial amounts of consumer receivables on their balance sheets. A newly created SPE would acquire capital by issuing equity and debt securities, and use the proceeds to purchase receivables from the sponsoring company, which often guaranteed the debt issued by the SPE. Because the receivables have limited and reliably measured risk of nonrepayment, a relatively small amount of equity usually was sufficient to absorb all expected losses, thus making it unlikel y that the sponsoring company would have to fulfill its guarantee. In this way the sponsoring company could convert receivables into cash while paying a lower rate of interest than the alternative of debt or factoring, as the debt holder could be repaid from the collection of the receivables or the sponsor. SPEs also allow the sponsors to remove receivables from their balance sheets, and avoid recognizing debt incurred in the securitization. …