Class #20 “Off Balance Sheet Activities” 15.535 - Class #20 1Where have we been/where next? • Quiz #2 will be handed back in Class on Thursday • Overview of Part 2 of Projects – Key due date is Friday, May 9, 2003. • Today: Off Balance Sheet Activities – Readings: Skim Section J of Course Reader “Leases and Off-Balance-Sheet Debt” (pages 531-540, 547-551) 15.535 - Class #20 2Off Balance Sheet Activities • Start with a simple example of lease accounting: – Understand the rationale for leasing and the distinction between Operating and Capital leases – Understand the Income Statement and Balance Sheet differences between Operating and Capital leases from the lessee’s perspective. • Examine the details of Off Balance Sheet Activities at Enron 15.535 - Class #20 3The Nature of Leases • A lease conveys the right to use property, plant or equipment for a stated period of time. – Lessee (the user or renter) – Lessor owner of the property • Economic Rationale for Leases: – Operational: • Leasing for short periods protects against obsolescence. • Lease “ready-to-use” equipment avoids set-up costs. • For equipment that is used seasonally, temporarily, or sporadically. 15.535 - Class #20 4Economic Rational for Leases • Financial Advantages to Lessee: – Lease payments can be tailored to suit the lessee’s cash flows (up to 100% financing, instead of the 80% limit by banks) – Properly structured leases my be “off-balance sheet”, avoiding debt-covenant restrictions – Leasing provides tax advantages from accelerated depreciation and interest expense. 15.535 - Class #20 5Economic Substance of Leases • Operating Lease: Lessee rents the property. Lessee records rent expense on income statement. Lease Rent Purchase • Capital Lease: Lessee economically owns the property. Lessee records the leased asset on balance sheet (ie capitalizes the asset) and reflects the corresponding lease obligation. 15.535 - Class #20 6Accounting Criteria for Lease Capitalization • A lease is considered a capital lease if ANY of the following conditions apply (SFAS 13): – Transfer of ownership at the end of the lease term. – Existence of a bargain purchase option payment below market value after the lease term. – Minimum present value of lease payments at least 90% of asset’s market value. – Lease term is for 75% or more of the asset’s remaining useful life. 15.535 - Class #20 7Capital Vs Operating Lease: Income Statement Effects Operating Lease (Rent Expense) Capital Lease Interest Expense + Depreciation Expense 15.535 - Class #20 8Capital Lease: Balance Sheet Effects Liability Lease Obligation (Capital Lease) Asset Leased Asset (Capital Lease) 15.535 - Class #20 9Background on Enron • On December 2, 2001, Enron Corp (7th largest U.S. company) declared bankruptcy. • Stock closed at $1 (down $83 within 1 year). • U.S. Senate Committee concluded that Enron’s Board of Directors failed in its duties: – Approved Off-Balance Sheet Partnerships run by Enron Employees – Failed to effectively monitor these partnerships – Failed to react to warnings about those transactions as they came to light 15.535 - Class #20 10The Bottom Line on Enron: • During 1990’s, Enron’s growth was driven by large investments in energy trading & energy, water and broadband assets Æ long delay before CF returns. • Instead of issuing equity, Enron chose borrowing through Off-Balance Sheet Partnerships (or SPE’s) to finance growth. • The SPE’s borrowed money from lenders who often required Enron to guarantee the debt (often done using Enron’s stock). 15.535 - Class #20 11The Bottom Line on Enron: • The effect of the SPE transactions was to link Enron’s credit rating (which was necessary for conducting its trading operations), and thus its viability, to its own stock price. • The effects of the slowing economy, poorly performing international investments, and the failure of a broadband initiative led the following: – Stock price decline, contingent liabilities realized, earnings hedges became insolvent, and finally bankruptcy ensued. All VERY fast! 15.535 - Class #20 12The Bottom Line on Enron: • Enron used financial leverage to manipulate reported earnings • Poor corporate governance placed firm in this position: – Lack of board independence & oversight – The auditor (Arthur Andersen) failed in its role as an independent certifier of results. – Compensation plans provided managers with incentives to maintain stock price at any cost. 15.535 - Class #20 13Prior Accounting Issues at Enron: • Enron reported 60% annual growth in revenues between 1995-2000 – Most of this was from energy trading revenues – Enron reported total dollar value of its trading volume as revenues (and cost of filling those contracts as COGS) – industry practice at the time • In 2001, Enron restated financial statements for 1997-200 to reflect the consolidation of previously unconsolidated SPEs: – Little impact on reported EPS: The consolidation did not reflect the debt of other unconsolidated SPEs 15.535 - Class #20 14The Death Spiral at Enron: • When Enron’s credit rating declined, counterparties refused to trade, unwound existing positions, and Enron’s trading business ground to a halt. • Enron had contingent liabilities (through SPEs) & exposures were revealed -> large magnitude of exposures hurt Enron’s credit rating. Enron could no longer support its energy trading operations. 15.535 - Class #20 15Off-Balance Sheet SPE’s at Enron: • SPE: an entity created by a sponsoring firm to carry out transactions: – Limited partnership, limited liability company, trust, or corporation – Sometimes called “Structured Financing Vehicles” if used to raise money or manage risk • In 1999, Enron had $33 billion of assets on its balance sheet and had an additional $27 billion in off balance sheet SPEs. 15.535 - Class #20 16Controversy over Enron’s SPEs: • Several large SPEs formed at the beginning of 1997 were run by related parties (Enron employees) • SPEs contained contingent liabilities that were not consolidated with Enron’s financial statements. • Some SPEs did not meet requirements for Off-Balance-Sheet reporting and should have been consolidated – Chewco Investments, L.P.; LJM Caymen, L.P.; LJM2 Co-Investment, L.P. 15.535 - Class #20 17Questionable Financial