Special Purpose Entities

The Use of Special Purpose Entities

There are many factors that contributed to the downfall of Enron’s empire but it was their strategic use of off-balance sheet entities that placed the use of special purpose entities under a microscope. A special purpose entity or vehicle is a legal, independent subsidiary established by the sponsoring corporation for a temporary time period to complete a particular purpose (Investopedia, 2016). The purpose for creating a special purpose entity would allow a corporation to offset risk, obtain tax benefits, and obtain a loan. Depending on the use of the created SPE, they can be legally structured as partnerships, joint ventures, trust, or corporations. Special purpose entities can be placed either on or off

Off balance sheet reporting has been the cause of stakeholders of various companies to lose thousands of dollars because liabilities are not fully disclosed on the parent company’s statement of position. Investors and other stakeholders use ratios such as the debt-to-equity ratio and return on assets ratio to determine a company’s ability to pay its long term debt. Operational leases, an example off balance sheet tool, is a financial structure that allows a company to use property, plant, or equipment without the legal rights to ownership. By creating an off balance sheet entity, sponsoring companies are not required to include special purpose entities on their balance sheet. Operational leases, often referred as synthetic leases present a problem for investors and other stakeholders because the balance sheet does not demonstrate an accurate scope of overall financial position. Under an operating lease, information about future obligations under the contracts must be disclosed in the notes to the financial statements. February 2016, IAS and FASB established the long-awaited AUS 2016-02 Leases (Topic 842), which will be go into full effect January 2019. Up until the announcement of AUS 2016-02, operating leases were only required to be disclosed on the footnotes of the annual 10-K filing reported to the SEC. On the exception of intangible assets, inventory, biological, and the use or exploration of natural resources leases, most operational leases

In 2006, the American International Groups (AIG) admitted securities fraud and improper accounting by creating special purpose corporations for the purpose of avoiding the public scrutiny of a declining financial position, ultimately manipulating investors and other stakeholders. Similar to Enron’s off-balance sheet techniques, AIG entered into a bogus contract with General Re Corporation to establish Cologne Re Dublin for the sole purpose of allowing AIG to inflate its loss reserves to a total $500 million dollars. In another deal with General Re, Capco Reinsurance Company, Ltd was created to hide about $200 million in underwriting losses by recording them as a capital loss. With this transaction, AIG had attempted to make their losses less embarrassing because an underwriting loss signifies the amount of insurance claims were greater than the amount of premiums collected. Union Excess, a subsidiary of AIG, was founded in 1991 in Barbados was also under scrutiny when AIG masked its controlling interest in Union Excess therefore the subsidiary’s balance sheet was not consolidated with AIG. As a result of AIG fraudulent activities, the insurance agency was fined and ordered to pay $800 million dollars in a settlement with SEC and other regulating