Using Special-Purpose EntitiesAbstract
Special-purpose entities are generally used to exchange property for stock or company ownership. Sounds innocent enough, but it gets a little dicey when you find out that there are many different types of special-purpose entities (SPEs), like joint venture, securitization and synthetic leases, and they are used for different scenarios. In the last 40 years the special- purpose entities went from being an out of the ordinary financing structure that was hardly used to one that is being used by U.S. and internationally. This paper touches on how the Financial Accounting Standards Board has many rules and interpretations of these SPEs and how they change or amend them quite often, especially since the Enron scandal and the financial crisis of 2008. After Enron there had to be changes to the way the business community handled special-purpose entities or many more companies would end up like Enron. It seems to be a big eye-opening experience for the business and accounting communities.
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Using Special-Purpose Entities
The FASB (Financial Accounting Standards Board) Codification states that a special-purpose entity is “a time sharing special-purpose entity is an entity, typically a corporation or a trust, to which a seller transfers time-sharing real estate in exchange for the entity’s stock, membership interests, or beneficial interests” (FASB, ASC 978-810-25-1, 2014). It seems when they were first being used the basic idea of the special-purpose entities was for companies to have an account to use in a temporary way to put money in so they could either move money around for special projects or so they could avoid financial risk. An Academy of Accounting and Financial Studies Journal article written by Anthony Amoruso and Jonathan Duchac (2014) states that “over the last four decades, SPE’s (special-purpose entities) have evolved from an exotic financing structure that was used sparingly, to a complex vehicle that is at the center of the U.S. and global financial systems” (p. 107). The impression is that there are many different reasons to use a special-purpose entity, but since the Enron debacle, it has come to light that many special-purpose entities were not being used as they were intended. Enron executives hid billions of dollars through the use of special-purpose entities. Even though the Enron scandal has given special-purpose entities a bad rap, the SPE can be salvaged. In an article written by Michael J. Macaluso and Abby E. Wilkinson (2003), they say “Legally speaking an SPE is formed by filing an organizational charter with the appropriate secretary of state” (p. 9). They continue to say, “The chartering document typically sports certain provisions designed to keep the SPE clean and isolated from its corporate parent” (Macaluso & Wilkinson, 2003). In 2003 the Financial Accounting Standards Board, also known as FASB, had plans to release rules for the new SPEs, which included implementing some new SPEs (Gregory, 2002). The Enron scandal caused a lot of pain, but it brought about change and opened the eyes of the business community.
Types of Special-Purpose Entities
Special-purpose entities were being used as far back as the 1970’s when many companies engaged in securitization (Soroosh & Ciesielski, 2004). Since special-purpose entities are commonly referred to as off-balance sheet activities most times they were used to deal with the risky business deals that didn’t need to be seen or the companies involved didn’t want to be seen by financial experts. The SPE is an entity created by an asset transferor to carry out a specific activity or series of transactions directly related to a specific purpose (Wilson & Key, 2012).
Securitization is the process of transforming loans receivable into securities, which is similar to in a sale of receivables or in a secured borrowing using the receivables as collateral (Briggs & Beams, 2012). In securitization the loans are pooled together and restructured into various debt securities, which make them more liquid. (Briggs & Beams)
Another transaction that used special-purpose entities was the synthetic lease. “This type of lease happens when a company wants to purchase building and land, but decides it needs to form a separate legal entity, an SPE, to purchase building. The SPE will get a loan for 90% of fair market value of the building from the bank and the company will get an outside equity investor to invest the remaining 10%, which will give the outside equity investor 100% of the shareholder equity in the SPE. All the outside equity is owned by someone other than the sponsoring corporation (13 Law & Bus. Rev. Am. 97).” A company can be a tenant for financial accounting purposes and an owner for tax purposes (Soroosh & Ciesielski, 2004). When a company does this do you think they really take pride in the building? Do they get the building to rent it out or to tear it down and build something else? A person would have to wonder what kind of tenant would they be and depending on the type of building they are buying, how well would it be for the community?
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Usually a joint venture takes place over one project and the parties involved are equally invested; however a new company is needed for the joint venture. From an article in Accounting Horizons, “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 unlikely 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 (Hartgraves & Benston, 2002)”.
Changing Special-Purpose Entities
Due to the fact that there were many financial disasters since Enron, both in the United States and overseas, there had to be extreme changes to the way the government agencies and the business world handled special purpose entities going forward. Changes had to be made and FASB continue to make changes when they determine that some things could be better. Right after the Enron scandal they established the FASB Interpretation 46, “Consolidation of Variable Interest Entities —An Interpretation of Accounting Research Bulletin (ARB) No. 51”, which will help companies better account for special-purpose entities. Of course FASB has to continually make changes to their rules and regulations to keep up with any discrepancies that they find every year. An article in Bank Accounting & Finance, written by Patrick R. Colabella, Adrian P. Fitzsimons & Vicoria Shoaf, explains how “FASB issued Statements of Financial Accounting Standards No. 166, Accounting for Transfers of Financial Assets – an Amendment of FASB Statement No. 140 (FAS-166), and FAS-167, Amendments to FASB Interpretation No. 46(R), to change the way entities account for securitizations and special-purpose entities (SPEs)” (p. 45). The articles continues on to explain, “FAS-166 revises FAS-140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, which eliminates the concept of a qualifying SPE (QSPE) and changes the requirements for derecognizing financial assets, and FAS-167 revises FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities (FIN 46(R)), which changes how a company makes the determination of when an entity that is insufficiently capitalized or is not controlled through voting should be consolidated (Colabella, Fitsimons, & Shoaf, p.45). Since Enron there have been many changes like this.
Special-purpose entities have been in existence for a long time. The people who used special-purpose entities to hide money at Enron seem to me to be people who don’t take no for an answer and they know how to get what they want. I don’t believe the special-purpose entities were meant to be used in the manner in which Enron used them. Although it sad that this crisis had to happen for the accounting and business world to be made aware of what was happening, many more people, like FASB and the Securities and Exchange Commission (SEC) are aware of what is happening with special-purpose entities now, and more rules and laws are being put in place to help keep everyone in line or within the law when it comes to special-purpose entities. After everything I’ve read it seems that FASB will probably always have to update the laws and rules pertaining to special-purpose entities because there are companies out there that will probably always find ways to hide money in an account. They always figure out a way to move it around or hide and then move it. Then when FASB finds out they will have to update or amend the law. It seems like it is just a cat and mouse game to some of these companies, like Enron, which is probably why they ended up where they are….nowhere.
13 Law & Bus. Rev. Am. 97. Retrieved from www.lexisnexis.com/hottopics/lnacademic
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Amoruso, A. J., & Duchac, J. (2014). SPECIAL PURPOSE ENTITIES AND THE SHADOW BANKING SYSTEM: THE BACKBONE OF THE 2008 FINANCIAL CRISIS. Academy Of Accounting & Financial Studies Journal, 18(2), 107-117.
Briggs, J. W., & Beams, J. D. (2012). Asset Securitization in a Changing Environment. CPA Journal, 82(9), 64-67.
Colabella, P., Fitzsimons, A. P., & Shoaf, V. (2009). New Guidance on Asset Transfers and Special-Purpose Entities. Bank Accounting & Finance (08943958), 23(1), 45-48.
FASB (Financial Accounting Standards Board). (n.d.). ASC 978-810-25-1. Retrieved July 3, 2014, from FASB Accounting Standards Codification database.
Gregory, M. (2002). FASB Update: Board proposes new class of SPEs. Asset Securitization Report, 2(23), 3.
Hartgraves, A. L., & Benston, G. J. (2002). The Evolving Accounting Standards for Special Purpose Entities and Consolidations. Accounting Horizons, 16(3), 245-258.
Macaluso, M. J., & Wilkinson, A. E. (2003). The Special Purpose Entity After Enron. Real Estate Finance (Aspen Publishers Inc.), 19(6), 9.
Soroosh, J., & Ciesielski, J. T. (2004). Accounting for Special Purpose Entities Revised: FASB Interpretation 46(R). CPA Journal, 74(7), 30-37.
Wilson, A. C., & Key, K. G. (2012). Enron: A Case of Deception and Unethical Behavior. Feature Edition, 2012(1), 88-97.