Witnesses testifying before two House Financial Services Committee subcommittees explained some of the fundamental problems with Enron Corp.'s financial reporting. A December 12 joint hearing of its Oversight and Capital Markets subcommittees featured testimony by Robert K. Herdman, the SEC's chief accountant, and Joseph F. Berardino, a managing partner and chief executive officer at Andersen LLC. Enron's November 8 filing with the SEC disclosed that three previously unconsolidated special purpose entities (SPEs) should have been included in its consolidated financial statements, according to Herdman. An SPE is an entity created by a sponsor to carry out a specified purpose or activity, such as to consummate a specific transaction or series of transactions with a narrowly defined purpose. They are commonly used as financing vehicles in which assets are sold to a trust or similar entity in exchange for cash or other assets funded by debt issued by the trust. In many cases, SPEs are used in a structured transaction or series of transactions to achieve off-balance-sheet treatment. In addition, use of SPEs can provide a lower cost of financing and create tax advantages. An SPE is expensive to set up and maintain, however. That's why SPE activities usually occur on a large scale so the impact of the reduced interest rate more than offsets the costs, according to Herdman. Most SPE transactions occur off-balance-sheet. Consequently, its financial information, including its assets and liabilities, does not appear in the transferring company's financial statements. Accounting literature regarding SPE consolidation is found in materials issued by the Financial Accounting Standards Board's (FASB) emerging issues task force. Herdman says two conditions must be met before an SPE can achieve off-balance-sheet treatment under generally accepted accounting principles (GAAP). First, the assets must be sold to the SPE and be legally isolated from the transferring company. Second, an independent third-party owner who has made a substantive capital investment that amounts to at least 3% of the SPE's total capitalization must both control the SPE and possess the substantive risks and rewards of owning its assets. "If executed properly, the legal isolation and the control by a third party reduce the risk of the creditor," said Herdman. "Thus, off-balance-sheet treatment of an SPE involves more than just sufficient third-party equity. This equity must be 'at risk' from the investor's perspective. If the investor's return is guaranteed or not 'at risk,' the transferring company would be required to consolidate the SPE in its financial statements." Three Enron SPEs did not qualify. Enron created four SPEs in 2000 and, as part of the initial capitalization and a series of ongoing transactions, issued its own common stock in exchange for notes receivable. "At the time, Enron increased notes receivable and shareholders' equity to reflect these transactions. However, in announcing its restatement, Enron disclosed that it had concluded that, pursuant to GAAP, these notes receivable should have been presented as a reduction of shareholders' equity," said Herdman. "GAAP generally requires that notes receivable arising from transactions involving a company's capital stock be presented as deductions from stockholders' equity and not as assets." Enron overstated both total assets and shareholders' equity by $172 million from a transaction first reported in its 2000 second-quarter results, and by another $828 million from a transaction that it reported in third-quarter 2001figures. Enron also disclosed that in the third quarter of 2001, it purchased a limited partnership's interest in an SPE, and that transaction resulted in a further reduction of shareholders' equity by $200 million. Andersen's Berardino said the accounting and auditing issues that Enron's collapse raise are extraordinarily complex and part of a bigger picture that is far from complete. Outside auditors use standards that provide reasonable, but not absolute, assurance that material errors will be identified. In the smaller Enron SPE, "we made a professional judgment about the appropriate accounting treatment that turned out to be wrong. On the one with the larger impact, it would appear that our audit team was not provided critical information." The larger SPE, an entity called Chewco, accounted for about 80% of Enron's SPE-related restatement. Enron and the California Public Employees Retirement System (Calpers) formed a 50-50 partnership in 1993 called Joint Energy Development Investments Ltd., or Jedi. Among other factors, that Enron did not control more than 50% of Jedi meant the partnership's financial statements could not be consolidated with the company's. Chewco bought out Calpers' interest in Jedi in 1997. Enron sponsored Chewco's creation and had investments in it. Rules do not bar company employees from being involved as investors in SPEs as long as the 3% and other tests are met. When Andersen audited the Chewco transaction in 1997, the auditors were given information from Enron that showed approximately $11.4 million in Chewco had come from a large international financial institution that was not related to Enron, Berardino said. Andersen recently learned that Enron had arranged a separate agreement with that institution under which cash collateral was provided for half of the residual equity. With this, the bank had only one-half of the necessary equity at risk. As a result, Chewco's financial statements since 1997 were required to be consolidated with Jedi's which, in a domino effect, then had to be consolidated with Enron's. "It is not clear why the relevant information was not provided to us." When Enron closed out the transactions that included the $172-million and $828-million equity amounts and Andersen reviewed the associated accounting with the company, the erroneous presentation of shareholders' equity came into focus, Berardino said. "We had discussed the proper accounting treatment for similar types of transactions with Enron's accounting staff, and therefore, the scope of our work on the year 2000 audit and this year's quarterly reviews did not anticipate this sort of error," he said. "When we informed the company of the error, it made the necessary changes in its financial statements." -Nick Snow