Required:
Determine how this transaction should have been accounted for assuming that
(a) Enron controlled LIM2 and used consolidated financial statements to report its investment in LIM2;
(b) Enron had significant influence over LIM2 and used the equity method to report its investment; and
(c) Enron did not have control or significant influence over LIM2 but LIM2 was considered a related party and Enron had to apply IAS 24: Related Party Disclosures.
Enron Corporation’s 2000 financial statements disclosed the following transaction with LIM2, a nonconsolidated special purpose entity (SPE) that was formed by Enron:
In June 2000, LIM2 purchased dark fibre optic cable from Enron for a purchase price of $100 million. LIM2 paid Enron $30 million in cash and the balance in an interest-bearing note for $70 million. Enron recognized $67 million in pre-tax earnings in 2000 related to the asset sale.
Investigators later discovered that LIM2 was in many ways controlled by Enron. In the wake of the bankruptcy of Enron, both American and Canadian standard-setters introduced accounting standards that require the consolidation of SPEs that are essentially controlled by their sponsor firm.
By selling goods to SPEs that it controlled but did not consolidate, did Enron overstate its earnings?
SOLUTION
a. If Enron controlled LIM2, Enron did overstate its earnings by reporting a profit of $67 million on a transaction with LIM2. When consolidated financial statements are prepared, the intercompany transaction between Enron and LIM2 would be eliminated and the fiber optic cable would be remeasured to the carrying value of this asset prior to the sale. The profit on the fiber optic cable would only be recognized on the consolidated income statement when LIM2 sells this cable to outsiders or through reduced depreciation expense over the useful life of this asset.
b. If Enron only had significant influence over LIM2, it would use the equity method to report its investment. Since Enron does not control LIM2, it would not be able to dictate the selling price of the cable. Since Enron only has significant influence, the interests’ of the other shareholders would have to be considered in setting the price. It would be similar to Enron selling to outsiders. IAS 28 states that profit pertaining to the other shareholders’ interest would be considered realized and need not be eliminated; only the investor’s percentage interest in the investee times the profit must be eliminated. The unrealized profit would be eliminated from investment income.
c. IAS 24 does not deal with the measurement of related party transactions. It only deals with the disclosure requirements for related party transactions.
If the transaction were to be reported at carrying amount, Enron would not report the gain. If the transaction were to be reported at exchange amount under IAS 24, Enron would be able to report the gain.
In most of the situations considered in this question, Enron should not have reported the gain. Gains from intercompany transactions are typically eliminated and not reported on the seller’s financial statement. Gains are typically not reported until they are realized in a transaction with a non-related party. This requirement applies to consolidated financial statements and an investment reported under the equity method but does not necessarily apply under related party transactions.