Enron was created in 1985 by the merger of two gas pipeline companies: Houston Natural Gas and InterNorth. Enron’s mission was to become the leading natural gas pipeline company in North America. As it adapted to changes in the natural gas industry, Enron changed its mission, expanding into natural gas trading and financing and into other markets, such as electricity and other commodity markets.

In the process Enron also made significant changes to several of its accounting procedures. For example, Enron began establishing several special purpose entities in many aspects of its business. A special purpose entity (SPE) is an entity—partnership, corporation, trust, or joint venture—created for a limited purpose, with limited activities and a limited life. A company forms an SPE so that outside investors are assured they will be exposed only to the risk of the SPE and its particular purpose, such as building a gas pipeline, and not to the risks associated with the entire company. In addition, the SPE also protects the investment of outside investors by giving them control over its activities.
Conditions for Non Consolidation of SPEs A company is not required to consolidate the assets and liabilities of an SPE into those contained on its own balance sheet, and it may record gains and losses on transactions with an SPE if two conditions are met:
1. An owner independent of the company must own a “substantive” equity interest (at least 3 percent of the SPE’s assets, and that 3 percent must remain at risk throughout the transaction).
2. The independent owner must exercise control of the SPE. The requirement of 3 percent minimum equity owned by outside investors was created in 1990 by EITF 90–15 and formalized by FASB Statements No. 125 and No. 140. This standard represented a major departure from typical consolidation rules, which generally required an entity to be consolidated if a company owned (directly or indirectly) 50 percent or more of the entity.4 Consolidation rules for SPEs were also controversial because a company could potentially use an SPE for fraudulent purposes, such as keeping debt or nonperforming assets off its own consolidated balance sheet. JEDI and Chewco In 1993 Enron and the California Public Employees Retirement System (CalPERS) formed an SPE: a \($500\) million 50–50 partnership they called Joint Energy Development Investments Limited (JEDI).5 Enron was not required to consolidate the partnership within Enron’s financial statements because it did not own more than 50 percent of the venture. In 1997 Enron offered to buy out......

Case Questions

1. Based on your understanding of the information presented in the case, how did Enron’s Chewco SPE fail to meet the outside equity requirement for nonconsolidation? Did Enron meet the control requirement for nonconsolidation?
2. Based on your understanding of audit evidence, did Arthur Andersen rely on sufficient and competent audit evidence in its audit of the Chewco transaction? Why or why not?
3. How would Section 401 apply to the Enron audit? Do you think Section 401 would have improved the presentation of Enron’s financial statements? Why or why not?
4. Identify one or more relevant financial statement assertions about at least one financial statement account related to the Chewco transaction. Provide adequate support for your answer.