How financial statements are manipulated — #3 off balance sheet vehicles
How are earnings manipulated? In this series of articles we look at some significant cases of financial manipulation. In this article we look at the use off balance sheet vehicles.
#3 Turn assets into equity — off balance sheet vehicles
Off balance sheet Special Purpose Vehicles (SPVs), allow a company to move assets and liabilities off a company’s balance sheet, whilst still potentially using those assets.
If you can transfer an asset off your balance sheet to a separate entity for more that the value it’s sitting on your books, then you can potentially recognise that difference as a gain in earnings. Voila. Increased earnings!
Andrew Fastow, once the CFO to Enron, is the off-balance sheet vehicle legend. At Enron he created 3,000 separate, off balance sheet, corporate entities!
Smoke & mirrors
Fastow used the SPVs for a variety of purposes, including collateralizing debt and moving impaired assets. In simple terms, he created a web so complex that it was impossible to discern the true liability position of Enron and enabled him to inflate earnings. [To boot, Fastow invested his own money in some of the SPVs and took out $60 million in fees!]
How it should work
According to International Financial Reporting Standards if a company (parent) controls an entity (a subsidiary), then consolidated financial statements need preparing. That is to say, all the assets and liabilities of the parent and subsidiary SPVs are added together in to one set of accounts.
So if a company retains control of an SPV then the consolidation defeats the purpose of the arrangement, ie. the asset and liability would still show on the consolidated balance sheet.
When control isn’t control
Control is usually considered to exist if 50% or more of the equity is held.
Arthur Andersen, the auditors to Enron, advised (rather dubiously) that if an “oversight committee” was in place at an SPV, then Enron could retain more than 50% of equity without actually having control. Not having control meant the assets and liabilities could be moved off the balance sheet.
In reality, all the Enron SPVs were run by the Enron management team, directly or indirectly, i.e. Enron had full control!
Create artificial gains on disposal
A common use of the SPV’s was for Enron to sell assets at above their book values (the values in the balance sheet) to the SPVs. Selling an asset at above book value can results in a gain, which potentially goes to the income statement, ie. increasing earnings.
Classify gains on disposal as operating profit
A gain on the sale of a fixed asset or investment isn’t usually part of the core operations of a business — unless that’s what the business specialises in. So a gain on the sale of an investment needs to be classified in the income statement as a one off gain.
Enron very rarely recognised these SPV disposal gains as one off, but hid them in operating profit, ie. giving the impression that these were repeatable earnings. Which to an extend they were, because they kept repeating the sham in subsequent periods!
Don’t impair assets
The assets and investments that were sold to SPVs were often ones that were about to be impaired, ie reduced in value. This was because Enron had overpaid for or overvalued the asset in the first place — which happened a lot.
An asset impairment is recognised in the income statement, ie. it reduces earnings. Enron very rarely impaired assets!
Guarantee SPVs with equity
Enron were able to support selling assets at over value to an SPV because Enron guaranteed the investments, with Enron stock, to the outside investors. These guarantees don’t show on the balance sheet but are hidden in the disclosure notes of the financial statements. With 3,000 off balance sheet vehicles, the Enron disclosure notes were some what complex!
These SPV guarantees were all well and good while the Enron stock price was rising, but as soon as it started to fall, covenants were breached and the true liabilities came to fruition. All $23 billion of them!
End result
In 2001 Enron filed for bankruptcy, which was then the largest in history (until WorldCom’s bankruptcy a year later).
Fastow pleaded guilty to two charges of conspiracy and was sentenced to ten years with no parole.
While Enron was imploding, an email was sent round to Andersen staff about document retention policy, which led to the shredding of thousands of documents.
This resulted in Andersens being charged with obstruction of justice (the conviction was subsequently overturned). This, amongst other failings, led to the downfall of Andersens and its 80,000 employees.
Next Week: #4 “Monetise” assets — turns future revenue into profit now
Simon Cook, Director, Lotus Amity
Simon specialises in providing forensic accounting services. Prior to founding Lotus Amity, he was a Forensic Accounting and Corporate Finance partner with BDO Australia and led their national forensic practice. Simon has assisted in many legal matters, including transaction disputes, damages claims, shareholder disputes and matrimonial matters. Simon is a Fellow of the Institute of Chartered Accountants of England and Wales and a Certified Fraud Examiner.
