Should the Regulators, Specifically the Financial Accounting Standards Board,
Be Blamed for the Enron Debacle?
by Jennifer Prashad
What are the Problems with Special Purpose Entities?
"The SEC Staff grew concerned about accounting for SPEs around 1985" (Ketz, 2003, p. 215). This was 15 years after the vehicle had become widely used in the industry. According to Bala G. Dharan (2004a) one of the major issues with accounting for an SPE is whether it should be consolidated with that of the sponsoring company. A report by the Staff of the US Securities and Exchange Commission (2003) noted, "The term, off balance sheet, has sometimes carried the connotation of something underhanded or at least less than fully transparent" (p. 7). In Enron's case, most of the SPEs were used in this manner. They were able to deceive investors because they did not consolidate the financial statements of the sponsoring company with that of the various SPEs. The accounting guideline, EITF 90-15, allowed a loophole for companies to not consolidate based on what has become the famous 3% ownership rule. In essence, the sponsoring company could own up to 97% of the SPE without consolidating it if 3% of the equity was owned by outside investors and was at risk. Bala G. Dharan (2004a) indicated that this 3% ownership rule "was a major departure" from the normal consolidation rules under GAAP (p. 119). GAAP requires that companies consolidate if they own 50% or more of equity interest in an entity. This loophole created by the FASB allowed Enron to not consolidate its debt. The result was that billions of dollars owed in liabilities was not included on the financial statements and was therefore unknown to the investors and creditors.
The FASB has since defended the 3% loophole by indicating that it was intended for certain types of lease transactions. However, when no guidance exists in the marketplace management will create and bend the rules to their advantage, often blatantly abusing loopholes. According to J. Edward (2003), the debt of the SPE also belongs to the sponsoring company since they own at least 97% of the company. Clearly this presents a conflict of interest for the parties involved. It is difficult to understand how the FASB could not have seen this conflict of interest that arose because of this arbitrary percentage ownership. Bala G. Dharan (2004a) explained the accounting problem that needs immediate attention is the issue of consolidation that arises with these types of entities. Unfortunately, three years after the Enron debacle, the FASB is still struggling with the rules to account for SPEs.
Mark-to-Market Accounting
Mark-to-Market (MTM) is an accounting method that is used mainly by energy traders. This type of accounting method allows revenues to be recorded on the financial statements before services are provided. Bala G. Dharan (2004b) points out the two conditions that must be present before revenues can be recorded: services must be provided and there must be a reasonable certainty that cash will be collected. The problem with Enron's use of this method is not that revenues were recorded before services were provided, but the gross abuse of this method that resulted. C. William Thomas (2002) explained that MTM accounting methods rely on management to predict revenues for future periods. In some cases, judgments are made without a proper valuation based for the future market values of the product. The crooked management of Enron used this opportunity to greatly inflate its financial statements. In accounting, nothing should be left to the discretion of the management because when decisions are left to be made by management, the results are often devastating to both creditors and investors, as Enron's demise has proven.
Enron's use of MTM accounting was approved by the SEC in 1992. Many companies soon followed suit because of the pressure to show earnings. If other companies had continued to use the conservative approach, their financial statements would not have stacked up against Enron.
Since management's discretion was needed for this type of accounting, Enron's management abused this method "on an unprecedented scale" to inflate its earnings (Thomas, 2002, p. 4). In testimony to the House Energy and Commerce Committee, Bala G. Dharan (2004a) stated that "without MTM [accounting], Enron would be required to recognize no revenue at the time the contract is signed and report revenues and related costs only in future years for actual amounts" (p. 121). However, when the tool to defraud is handed down by a regulator, in this instance the SEC, companies will not only abuse their privileges to the fullest extent, but will feel they are doing so lawfully.
Did the Changes or Lack of Changes by the FASB Contribute to Enron's Demise?
The first official guidance published by the FASB and EITF in 1990 that dealt with the accounting methods for SPEs was EITF 90-15. This ruling was formalized by FAS 125 and eventually "replaced by FAS 140" (Bentson & Hartgraves, 2002). These pronouncements were limited in scope and did not fully account for the various scenarios that may exist in the complexities of different industries. While EITF 90-15 presented a loophole, two revisions by the FASB (FAS 125 and FAS 140) did not revise the 3% arbitrary guideline. Most professionals believe the standards were set too low. Specifically, the rulings allowed "firm[s] to own up to 97% of an SPE without reflecting either its assets or liabilities on the firm's balance sheet" (Crawford & Edward, 2003). This resulted in the sponsoring company having a great deal of control and influence on the SPE's activities. This loophole created by the FASB clearly allowed Enron to avoid consolidation of its SPEs, leading to its demise. Enron's eventual correction of the financial statements revealed that the SPEs' debt amounted to billions of dollars, which Enron was solely responsible for. When investors realized this they quickly sought to dump their stock, resulting in the company losing its value almost overnight.
In an attempt to comply with the Sarbanes Oxley Act of 2002, the FASB in 2003 revised the 3% guideline to 10% in its pronouncement FIN 46(R). Companies are now required to consolidate financial statements if they own at least 90% of the voting interest in the SPE. Edward J. Ketz (2003) suggested this ruling is still disappointing because it "creates three loopholes to allow business entities a way out" (p. 141). Unfortunately, the revised pronouncement still has loopholes to allow another Enron-type scandal.
Enron's use of MTM accounting methods was approved by the SEC. While this method has its legitimate use, it relies too much on management to forecast future revenues. Since judgment can be made without a substantial basis, it would be easy to pull numbers out of thin air. "In the end, the accounting standard-setters took the position that the increased benefit from reporting the market value information on the balance sheet justified the cost of decreased reliability of the income statement and earnings number" (Dharan, 2004a, p. 118). If the regulators will overlook the reliability of the financial statements, corporate America will only be too happy to follow their lead.
Conclusion
While the debate about the true reason for Enron's collapse will probably be carried on into the next decade, and beyond, there are many established facts to ponder. Major among these is the role the regulators may have played, knowingly or unknowingly. The mere structure of the FASB can be seen as a contributing factor. It should not have to take 15 years for a regulatory agency to release guidance, as was the case with the SPEs. Being reactive and not proactive set the stage for gross abuse and outright fraud. Enron's endeavor to be a top US corporation was surely reason enough to take advantage of the MTM accounting and SPEs loopholes left in place by the FASB. These loopholes were just never abused to the levels that Enron took them.
To prevent this from happening again, the FASB should be strengthened and revamped. It has to be independent of the SEC and Congress. Both the SEC and Congress have invisible hands in the accounting rule making policies that quite often contradict the FASB aims. Dharan's (2002b) testimony to the House Energy Committee revealed the need for the FASB to be independent. An arm's length relationship with the SEC and Congress is necessary in order for the FASB to provide policies that are not politically motivated. Weil (2002) made it evident that Congress needs to "keep out of accounting rule making" (p. 5). More importantly, the FASB should close all loopholes as fast as they are discovered. By doing so, another Enron-like disaster may be prevented.