Should the Regulators, Specifically the Financial Accounting Standards Board,
Be Blamed for the Enron Debacle?
by Jennifer Prashad
Enron's accounting methods for its Special Purpose Entities (SPEs) were but one of the major factors that contributed to its demise. According to Bala G. Dharan (2002a), "SPEs are business entities formed for the purpose of conducting a well-specified activity, such as the construction of a gas pipeline, collection of a specific group of accounts receivables, etc." (p.3). Enron's use of SPEs, although perhaps legitimate at first, was used to "remove assets and liabilities from its balance sheet, to hide losses, and to create fictitious profits" (Duncan and Schmutte, 2005, p.1). Accounting for SPEs can be done in different forms. The FASB has worked injudiciously over a number of decades to come up with one set of accounting measures for these vehicles. Since Enron's debacle, SPEs and MTM accounting methods have been under scrutiny by both the public and governmental regulatory agencies.
The debacles of 2001-2002 forced the public to lose faith in the accounting process and the agencies responsible for regulating them. As a result, there have been many changes in both the public and private sector to regain the public's trust. Congress has enacted the Sarbanes Oxley Act of 2002 (the Act) which required major changes to the auditing and accounting profession. In addition the Act mandated that the FASB revise its guidance on SPEs. This research paper examines the accounting methods enacted by the regulators, specifically the FASB, to determine if it was responsible for the Enron debacle. In order to understand the role the regulators have in the private sector an overview of the structure is presented first. Thereafter, the paper focuses on SPEs and the accounting dilemmas surrounding them. Subsequently, the MTM accounting method is discussed. Finally, the paper considers whether these changes (or lack of changes) by the FASB contributed to Enron's debacle.
The Regulators' Structure
The regulators include the Financial Accounting Standards Board (FASB), the Securities and Exchange Commission (SEC), and Congress. While various regulatory bodies influence the accounting methods used in the private sectors, the FASB is the primary standard setter in the United States. The FASB was created by the SEC and works closely with it to release guidelines. J. Edward Ketz (2003) stated the "SEC was given the authority to create financial statements and accounting methods based on Section 19(a) of the Securities Act of 1933 and Section 13(b) of the Securities and Exchange Act of 1934" (p. 214). However, the SEC delegated this responsibility to the FASB but retained overall control of all final pronouncements. Since the SEC was created by Congress through the Securities and Exchange Commission Act of 1934, Congress also indirectly controls the FASB. This was evident most recently, as Roman L. Weil (2002) indicated, in 1990 when Congress used its power to make the FASB pull back on their proposals for expensing stock options.
The FASB has a unique approach before creating guidelines. It first issues exposure drafts to the public, requesting feedback. At best this can be described as a compilation of best practices in the field. As a result, it is often slow in responding to creative and innovative accounting methods. Bala G. Dharan (2004a) stated that the "standard setters were always a step or two behind (and were being reactive rather than proactive) in developing account rules to govern their proper use" (p. 119). Hence, many of the issues that exist in the market place are in use for a couple of years before the FASB addresses them. Al L. Hartgraves and George J. Bentson (2002) stated that the FASB took approximately 15 years before releasing any specific guidance on SPEs. Despite this evident lack of response, the FASB in its mission statement still claims to "consider promptly any significant areas of deficiency in financial reporting that might be improved through the standard setting process" (Facts about the FASB). When pronouncements are eventually published, they are released as Generally Accepted Accounting Principles (GAAP) and are followed by the private sector when preparing financial statements. A subsidiary of the FASB, Emerging Issues Task Force (EITF), is tasked with providing guidance on issues that the FASB has not addressed.
What are Special Purpose Entities?
Special Purpose Entities became widely used in 1970-1980, but have been put under tremendous scrutiny because of Enron's misuse and abuse of them. They are set up by another company (sponsoring company) and can take any legal form such as a corporation, partnership and trust. The sponsoring company creates this entity for a specific activity. According to Hartgraves and Bentson (2002), the SPEs have a limited scope because their "activities," "life," and "purpose" are only to benefit the sponsoring company (p.1). Unfortunately, Enron's SPEs were used to benefit the management's personal goals more than those of the shareholders. "The term 'special purpose' comes from the limited scope of the charter of the SPE" (Dharan, 002a,p. 4). Once the purpose of the entity is fulfilled, it dissolves. J. Edward Ketz (2003) indicated that this type of entity allows the sponsoring company to borrow money, transfer or sell assets to it. SPEs, when used legitimately, provide investors and businesses with an effective tool. Investors' risk is limited to the activities of the SPEs, while the sponsoring company benefits by keeping the liabilities off its books, resulting in a positive debt to equity ratio. Although these entities have been around for a while, there had been no official guidance set for them by the FASB until 1990, when EITF 90-15 was issued to help companies account for these vehicles.