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ENRON SPEs

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Enron Corporation's 2001 third-quarter 10-Q report disclosed the following transaction with LJM2, a nonconsolidated special purpose entity (SPE) that was formed by Enron:

In June 2000, LJM2 purchased dark fiber optic cable from Enron for a purchase price of $100 million. LJM2 paid Enron $30 million in cash and the balance in an interest bearing note for $70 million. Enron recognized $67 million in pretax earnings in 2000 related to the asset sale. Pursuant to a marketing agreement with LJM2, Enron was compensated for marketing the fiber to others and providing operation and maintenance services to LJM2 with respect to the fiber. LJM2 sold a portion of the fiber to industry participants for $40 million, which resulted in Enron recognizing agency fee revenue of $20.3 million.

As investigations later discovered Enron controlled LJM2 in many ways.

The FASB ASC now requires the consolidation of SPEs (variable interest entities) that are essentially controlled by their primary beneficiary.

By selling goods to SPEs that it controlled but did not consolidate, did Enron overstate its earnings? What effect does consolidation have on the financial reporting for transactions between a firm and its controlled entities?

Please include the source.

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Solution Summary

This solution discusses the use of Enron's SPE's in overstating earnings. The effects of the consolidation between the firm and controlled entities is also discussed. A comprehensive discussion is provided.

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By selling goods to SPEs that it controlled but did not consolidate, did Enron overstate its earnings?

Enron definitely overstated its earnings by selling goods to SPE's it controlled. It is a direct way to manipulate earnings, and was done so in a very unethical and illegal manner, in this case. In accounting, we have what's called an arm's length transaction. All transactions must be conducted at an arm's length - meaning no close relationship between the buyer and the seller. This is also referred to as related party transactions, by the AICPA. When auditors (Arthur Andersen) ...

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