More Lessons from ENRON

George Mundstock writes:

Discourse.net: Enron's Special Purpose Entities: EMy pet gripe in the whole accounting simplification debate is how business and the accounting industry cite Enron as evidence that we need less detailed rules. They argue that detailed rules provide a roadmap for technical compliance that violates the spirit... [while] simple rules could not be gamed.

In fact, Enron demonstrates the need for detailed rules.

Enron is best known for its use of Special Purpose Entities (SPEs) to manipulate accounting results. Enron would own most of a subsidiary corporation or partnership, but outsiders would have voting control, so that the entity would not be treated as part of Enron on its (consolidated) financial statements. Practice at the time was that outside investors put up at least 3% of the equity capital. In fact, in many of the Fastow/Enron deals, outsiders did not, and would not, put up 3% because the deals were so screwy. Clear rules worked. (Substantive accounting rules cannnot stop fraud.) End of story.

But, argues business, the 3% was so tempting that it encouraged the deals. Rather, if the rules left the separateness decision to the accountant's judgment, she would have stopped these deals. Wrong! Details below.

The 3% rule came from a 1990 pronouncement of an ongoing task force on emerging accounting issues that was formed by the Financial Accounting Standards Board. This pronouncement dealt with SPEs formed to do sale/leaseback transactions. (The SPE would lease debt-laden property to its economic parent in order to get the debt off the parent's financial statements. Tax benefit transfers to the outside 3% usually also were involved.) The exact language of the pronouncement was:

The initial substantive residual equity investment should be comparable to that expected for a substantive business involved in similar... transactions with similar risks and rewards. The SEC staff understands from discussions with Working Group members that those members believe that 3 percent [now 10 percent] is the minimum acceptable investment. The SEC staff believes a greater investment may be necessary depending on the facts and circumstances, including the credit risk associated {with the SPE's activities]...

Enron's SPEs did incredibly risky hedging, not safe sale/leasebacks, and yet nobody even thought about requiring more than 3% outside equity. In other words, the rule applied in Enron had a non-detailed facts and circumstances test in addition to the 3% rocky shoal, and the non-detailed rule failed completely!

Enron's SPEs did no hedging at all. They were ways of having the company bet that its stock price would continue to rise.