Please provide an answer for the question and explain your reasoning. The first two pictures are part of the same question.

CASE STUDY BASIN WATER. INC*. Examine extracts from the selected financial statements from Basin Water, Inc., for the fiscal years ended 2005, 2006, and 2007. Examine Note 9 and Note 15 to Basin Water's Consolidated Financial Statements for 2007. Respond to the following Case Study questions. Required . a. Improper Use of SPEs: The SEC's Complaint (2011) against Basin Water, Inc. alleged: "The Defendants Materially Overstate Basin's Q2 2007 And Year-To-Date Revenues By Engaging In A Sham $3.8 Million Sale To A Special Purpose Entity They Directly Or Indirectly Cause To Be Created" (section F). After review- ing the signals for Enron's schemes of using SPEs to understate debt and to overstate earnings, identify the signals of the improper use of unconsolidated affiliates, or SPEs, that were present in the Enron case and can allegedly be found in Basin Water's notes to its financial statements. Explain why those signals could have been indica- tions that Basin Water may have alleg- edly overstated its sales and under- stated its loss. Extracts from FORM 10-K Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the fiscal year ended September 31, 2006 BASIN WATER, INC. Balance Sheets in thousands except share and per share data) December 31, December 31, 2006 2005 ASSETS Current assets Cash and cash equivalents $ 54,567 5 2.724 Accounts receivable, net of 567 and 50 allowance for doubtful accounts 2416 3.927 Unbiled receivables, net of 5433 and 50 allowance for doubtful accounts 9,123 3,123 Inventory 714 347 Prepad expenses and other 634 189 Notes recewable 100 Total current assets 67454 10.410 Property and equipment Property and equipment 13,521 10.445 Less accumulated depreciation 1,394 962 Property and equipment, net 12227 9.483 Other assets Long-term unbiled receivables 7.466 2.744 Patent costs, net 383 286 Loan costs, net 37 Other assets, net 2.485 Total other assets 10371 3.905 Total assets 590052 23 299 UABILITIES AND STOCKHOLDERS' EQUITY Current liabilities Accounts payable $ 15625 2,150 Current portion of notes payable 2.007 674 Current portion of capital lease obligations 17 15 Current portion of deferred revenue and advances 292 741 Current portion of contract loss reserve 1321 Accrued expenses and other 2.291 273 Total current liabilities 7490 3,853 (continued * Extracted from 16-K filings for Basin Water, Inc. 2005-2007 Obtained from US Securities and Exchange BODO 286 Chapter 7. Enron and the Tale of the Golden Goose December 31, December 31, 2006 2005 10 6,878 24 40 387 439 2,404 2.250 6,529 10,315 19,989 Notes payable, net of current portion and unamortized discount Capital lease obligations, net of current portion Deferred revenue, net of current portion Contract loss reserve, net of current portion Redeemable convertible Series A preferred stock, no par value-6,000,000 shares authorized, 0 and 627 500 shares issued and outstanding Redeemable convertible Senes B preferred stock, no par value5,000,000 shares authorized, 0 and 1.734, 125 shares issued and outstanding Total liabilities Commitments and contingencies Stockholders' equity Common stock, no par value40,000,000 shares authorized, 10,303,047 shares issued and outstanding Common stock, 50.001 par value-100,000,000 shares authorized 19,887,672 shares issued and outstanding Additional paid-in capital Accumulated deficiency Total stockholders' equity Total liabilities and stockholders' equity 7.927 20 95,002 (15.285) 79,737 $ 90,052 (4,118) 3.809 $ 23,798 Extracts from FORM 10-K For the fiscal year ended December 31, 2007 BASIN WATER, INC. Consolidated Balance Sheets (in thousands, except share and per share data) December 31, December 31, 2007 2006 ASSETS Current assets Cash and cash equivalents 5 35,456 $ 54,567 Accounts receivable, net of 572 and 567 allowance for doubtful accounts 3,167 2,416 Unbilled recewables, net of 5524 and 5433 allowance for doubtful 11.443 9,123 accounts Inventory 1,055 714 Current portion of notes receivable 338 Prepaid expenses and other 1.233 Total current assets 52,692 67.454 Property and equipment Property and equipment 15,945 13,621 Less accumulated depreciation 1.645 1,394 Property and equipment net 14,300 12,227 (continued Extracted from 10-K filings for Busin Water, Inc. Obtained from US Securities and Exchange Commission www.secgo December 31, December 31, 2007 2006 7466 8,682 7,664 1,015 3,416 2.2 74 4,502 1,667 31.220 $98 212 1.641 383 881 10.371 590052 53.553 Other assets Goodwill Unbiled receivables, net of current portion Notes recevable, net of current portion Intangible assets, net Patent costs, net Investment in affiliate Other assets Total other assets Total assets UABILITIES AND STOCKHOLDERS' EQUITY Current liabilities Accounts payabile Current portion of notes payable Current portion of capital lease obligations Current portion of deferred revenue and advances Current portion of contra los reserve Accrued expenses and other Total current liabilities Notes payable, net of current portion Capital lease obligations, netof current portion Deferred revenue, net of current portion Deferred revenue aflate Contract loss reserve, netof current portion Deferred income tax liability Other long-term liabilities Total liabilities Commitments and contingencies Stockholders' equity Common stock, SO 001 par value-100,000,000 shares authorized, 21.948,704 and 19,887672 shares sued and outstanding Additional paid capital Treasury stock Acumulated deficiency Total stockholders equity Total liabilities and stockholders' equity 266 1964 3,140 5 1562 2.007 17 292 1.321 2.291 7,490 10 8.934 15 387 2.404 296 1.920 5311 2.268 179 18923 10315 22 20 95.002 110.354 (552) 30 535) 79 289 598212 (15.285) 79,737 5.90 052 The accompanying notes are an integral part of these consolidated financial statements Basin Water, Inc. Consolidated Balance Sheets in thousands, except per share data) Years Ended December 31, 2007 2006 2005 $ 13,477 $ 13,861 5 10,016 5,307 3,253 2.215 18,784 17,114 12,231 13.790 10,698 443 24,931 (6,147) 564 13,685 (20,396) 12,161 7,522 423 20.106 (2.992) 634 6,827 (10,453) 4,467 2,323 340 7.130 5.101 651 3,334 1.116 Revenues System sales Contract revenues Total revenues Cost of revenues Cost of syster sales Cost of contract revenues Depreciation expense Total cost of revenues Gross profit (loss) Research and development expense Selling, general and administrative expense Income (loss) from operations Other income (expense) Interest expense Interest income Gain on sale to affiliate Other income Total other income (expense) Income (loss) before taxes Income tax benefit Net income (loss) Net Income (loss) per share: Basic Diluted Weighted average common shares outstanding: Basic Diluted (621) 52 (98) (2.781) 2.736 2,061 2,500 8 6 5,146 (714) (15,250) (11,167) 16 (553) 563 5 (15,250) 5 (11,167) S 563 S (0.76) S (0.70) S 0.06 5 (0.76) S (070) 5 0.04 20.185 20,185 16,048 16,048 9,924 12,849 Basin Water, Inc Consolidated Statements of Cash Flows an thousands) Years Ended December 31, 2007 2006 2005 5 (15,250) 5 (11,167) 5563 Cash flows from operating activities Net income (loss) Adjustments to reconcle net loss to net cash provided by operating activities Depreciation and amortization Stock-based compensation expense Gain on sale to affiliate ksuance of warrants for services Wnite off of loan acquisition costs 995 1,706 (2.500) 1,024 744 506 31 417 34 401 - (continued) Chapter 7 Enron and the Tale of the Golden Goose Years Ended December 31, 2007 2006 2005 (1,817) (4,489) 103 (367) (542) (445) 1.600 (588) (117) (501) (1,515) 2,018 3,550 3,725 4,091 636 (3,353) (207) (3386) (13,256) (12,361) (6,279) (268) (80) 1,468 354) 397 (2.810) (6.409) (5,347) (6,214) (3,942) (1.913) Changes in operating assets and abilities Accounts receivable induding unbilled Inventory Prepaid expenses and other Accounts payable Deferred revenues Accrued expenses and other Contract loss reserve Net book value of systems sold Issuance of notes receivable Other assets and other liabilities Net cash used in operating activities Cash flows from investing activities Purchase of property, plant and equipment Acquisition of business, net of cash acquired Collection of notes receivable Patent costs Net cash used in investing activities Cash flows from financing activities Issuance of common stock Repurchase of common stock Proceeds from employee stock option exercises Proceeds from warrant exerases Issuance of redeemable preferred stock Proceeds from notes payable Loan origination fees Repayments of notes payable and capital lease obligations Net cash provided by financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents, beginning of period Cash and cash equivalents, end of period 100 (99) (31) (11,592) 325 (107) (1,695) (3,941) 75,178 3,584 (552) 527 162 8,060 596 2.000 5,156 (100) (100) (2,298) (9,095) (112) 5.737 68,145 9,124 (19,111) 51,843 1,020 54,567 2,724 1,704 $ 35,456 $ 54,567 5 2.724 From Basin's 10-K 2007 NOTES, Pages F20-722 Note 9: OTHER ASSETS Goodwill The table below summarizes the changes in the carrying amount of goodwill for the year ended December 31, 2007 Balance at December 31, 2006 5 Acquisition of business during the period 8,682 Balance at December 31, 2007 58,62 Long-term Accounts Receivable and Notes Receivable The Company has four cus tomer system sales agreements which provide for payment terms ranging from two to five years, unless certain conditions are met, in which case the payment terms are accelerated. At December 31, 2007 and 2006, the amount of long-term accounts receiv- able was $7,661 and $7,466, respectively, which represents the balance due from these four customers under the extended payment terms. In 2004, in connection with the sale of a system, the Company received a $300 unse- cured note that provides for interest at a rate of 3% per annum. The Company received a payment of $200 in connection with this note in 2005. The final principal payment of $100 became due in 2006, and as such, the note has been classified as current. The Company has reserved $67 of this note as of December 31, 2007 and 2006. Both the note and the related allowance for doubtful accounts have been classified as current assets and are included in the accounts receivable balance at December 31, 2007 and 2006. At December 31, 2007, long-term notes receivable consist of non-interest bear- ing notes receivable from VL Capital, due in 72 monthly installments of $63 beginning April 2008, with a net present value of $3,353, calculated using an imputed interest rate of 5.0% per annum Intangible Assets Net intangible assets are as shown in the following table as of the dates indicated December 31, 2007 2006 Deferred stock based compensation 5189 $ 394 Fair value of warrants, net 916 1.210 Service agreements and contracts 1.299 Customer relationships 560 Covenant not to compete 295 Trade game 157 Loan costs, net 37 Intangible assets, net $3,416 51 641 The amortization period of intangible assets are as follows: customer relationships-15 years, covenant not to compete--three years, trade name-two years, service agreements and contractssix years, deferred stock-based compensation- three years, and fair value of warrants issued to a joint venture partner-five years. Patent Costs The Company capitalizes costs of patent applications. As a result of the September 2007 acquisition of MPT, the Company recorded an additional $1812 repre- senting the fair value of patents acquired. When patents are issued, the Company amor tizes the patent cost over the life of the patent, usually 17 years. Future amortization of patent costs at December 31, 2007 is approximately $107 per year for each of the five years ended December 31, 2008 through 2013, and $107 each year thereafter through 2024. If a patent is denied, capitalized patent costs are written off in the period in which a patent application is denied. Investment in Empire Water Corporation (Empire) In May 2007, the Company entered into an agreement to acquire certain water rights and related assets. In December 2007, the Company sold its rights to purchase these assets to Empire. As consideration for the sale of these assets, the Company received 6,000,000 shares of Empire common stock, which represents an ownership interest of approximately 32% in Empire as of December 31, 2007 The Company accounted for the December 2007 transaction under the equity method. Specifically, the Company recorded $2,500 as gain on sale to affiliate upon the receipt of the shares of Empire common stock by estimating the fair value of such stock based upon concurrent sales of Empire common stock to third parties, and reducing the fair value by the Company's ownership interest in Empire. This reduction of approx mately $1,900 has been recorded as deferred revenue-affiliate on the balance sheet of the Company at December 31, 2007 The Company has recorded its investment in Empire at approximately $4,500, while the amount of underlying equity in the net assets of Empire is approdimately $3.000. The dif ference of approximately $1 500 represents the excess of the market value of the Company's investment in Empire over the Company's 32% interest in the net assets of Empire The following tables present summarized information concerning the assets, liabilities and results of operations of Empire for the most recent periods for which information is available: Assets Labilities Dec 31, 2007 $9450 $ 101 Six Months Ended Dec 31, 2007 5 Year Ended June 30, 2007 5 33 Revenues et loss From BASIN's 10-K 2007 NOTES, Page 27 Note 15: RELATED PARTY TRANSACTIONS The Company paid legal fees to a legal firm whose partner is a director. The total payments for legal fees to this firm were $315, $192 and $154 for the years ended December 31, 2007, 2006 and 2005, respectively The Company also leases office space and equipment from two individuals, one of whom is a director and employee and the other an employee, under month-to-month agreements. The total payments under these related party rental agreements were $57. $54 and 555 for the years ended December 31, 2007, 2006, and 2005, respectively In May 2007, the Company entered into an agreement to acquire certain water rights and related assets. In December 2007, the Company sold its rights to purchase these assets to Empire. As consideration for the sale of these assets, the Company received 6,000,000 shares of Empire common stock, which represents an ownership interest of approximately 32% in Empire as of December 31, 2007 The Company accounted for the December 2007 transaction under the equity method. Specifically, the Company recorded $2,500 as gain on sale to affiliate upon the receipt of the shares of Empire common stock by estimating the fair value of such stock based upon concurrent sales of Empire common stock to third parties, and reducing the fair value by the Company's ownership interest in Empire In addition, Empire agreed to purchase one water treatment system from the Company concurrent with the December 2007 closing for a total price of $900. During the year ended December 31, 2007, the Company recorded $653 of system sales rev- cue and $287 of gross margin on this transaction under the percentage-of-completion method of revenue recognition. The Company has recorded $92 as a charge against other income under the equity method, which represents 32% of the Company's gross margin on this system sale to a related party. SIGNALS OF THE ENRON FRAUDS A number of red flags in Enron's financial statements indicated that Enron had been using off-balance sheet entities or SPEs to understate debt and overstate earnings. Signals of Enron's Fictitious Reporting Schemes of Using SPEs (or Unconsolidated Affiliates) to Understate Debt and Overstate Earnings Because SPEs are usually equity investments-investments in which the investor acquires an ownership interest in the investeethe information about SPEs is often included but hidden among the other equity investments on the investor's balance sheet. Generally, equity investments in companies fall into one of three categories: 1. Holdings of less than 20 percent, where the investor has a passive interest in the investee. The investee's assets and liabilities are not consolidated into the inves- tor's group balance sheet. Income is recognized when dividends are declared. 2. Holdings of between 20 percent and 50 percent, where the investor is deemed to have significant influence, but not control, unless information to the contrary exists. These investments are often classified as "investments in unconsolidated affiliates" on the balance sheet. The assets and liabilities of the affiliate are not consolidated into the investor's group balance sheet. The investor accounts for its share of the investee's income using the equity method. 3. Holdings of more than 50 percent of the equity of the investee, where the investee is deemed to have a controlling interest. The investee's financial statements are consolidated into the investor's group financial statements. The three categories become blurred, however, when investors or sponsors create SPES. SPEs are usually "created by a party (the transferor or the sponsor) by transfer- ring assets to another party (the SPE) to carry out a specific purpose, activity or series of transactions. Such entities have no purpose other than the transactions for which they were created" (Soroosh & Ciesielski, 2004). They are often partnerships, joint ventures, or trusts, and sometimes they are corporations. In pre-Enron accounting, because such entities operate for a specific purpose, the Emerging Issue Task Force (EITF 90-15) allowed SPEs to be excluded from consolidation with the sponsor's group financial statements "as long as the equity interest of a third- party owner was at least 3% of the SPE's total capitalization, the same time, the major- ity of equity voting rights cannot reside with the beneficiary" (Soroosh & Ciesielski, 2004). Many companies began to bend the rules and create entities over which they had control, in which they had invested most of the equity capital (except for 3 percent), and for which they had further obligations for the entities' debt. They used the non- consolidation rule to avoid including such SPES' debt in their balance sheets and to avoid eliminating profit on related-party transactions with these entities. These invest- ments in off-balance-sheet entities were often lost or hidden in the investor's balance sheets as though they were typical investments in unconsolidated affiliates where the investor holds between 20 percent and 50 percent of the investee. As previously mentioned, post Enron, accounting for SPEs was updated by the Financial Accounting Standards Board Interpretation FIN 46 (R) as amended by FASB No. 167 (2009). The latest guidance for consolidation is the ASC 610 proposed update issued in 2011. The Board estimates a final update will be issued in the second half of Chapter 7 Enron and the Tale of the Golden Goose 2014. In essence, under FIN 46(R), if a sponsoring company has an investment in an entity that is not self-supportive and there is a possibility that the investor may need to provide further financial support, the investee must be defined as a variable interest entity (VIE) VIEs must be consolidated into a company's group financial statements if the company is a primary beneficiary of the VIE The FASB Summary of Statement No. 167 (2009) identifies the primary beneficiary as: [T]he enterprise that has both the following characteristics: 1. The power to direct the activities of a variable interest entity that most signifi- cantly impact the entity's economic performance 2. The obligation to absorb losses of the entity that could potentially be significant to the variable interest entity or the right to receive benefits from the entity that could potentially be significant to the variable interest entity In addition, disclosure is also required in the MD&A section regarding certain details of off-balance sheet arrangements. The proposed accounting standards update ASC 810,"provides criteria for a reporting entity to evaluate whether a decision maker is using its power as a principal or an agent . These criteria would affect the evaluation whether an entity is a variable interest entity and, if so, whether the reporting entity should consolidate the entity being evaluated" (FASB News Release, Nov. 2011). It is important to note that pre-Enron accounting rules also required many of Enron's unconsolidated SPEs to be consolidated into Enron's financial statements, but Enron - failed to consolidate many of its now infamous SPES. If some companies broke the old rules requiring certain off-balance-sheet entities to be consolidated, some will likely be tempted to break the new rules as well. Therefore, hints in financial statements and notes are instructive for telltale signs of problematic SPES. Enron's SPEs were hidden mainly among its investments in unconsolidated affili- ates and other investments. Hints were left in references in the notes to the financial statements regarding unconsolidated affiliates and also in the notes regarding related- party transactions, guarantees, and sales" where some ownership rights in the "sold assets" were retained by the seller. There were also vague references, in notes to the financial statements, to investments in partnerships and trusts and the financing of such entities with Enron's own stock. SIGNAL #1: ASSETS AND LIABILITIES OF UNCONSOLIDATED AFFILIATES OR SPES INCREASING SIGNIFICANTLY When the amount of the assets and liabilities of unconsol- idated affiliates or SPEs grows significantly, it is an indication that the company could be using off-balance sheet entities to hide its debt or overstate its earnings. In Enron's "Notes to the Consolidated Financial Statements in its Annual Report, the note titled "Unconsolidated Equity Affiliates" showed that the magni- tude of the assets and liabilities of the unconsolidated affiliates was alarming-the total liabilities grew from $8.3 billion in 1997 to $20.6 billion in 2000. Given that off- balance-sheet entities are often used to hide debt by removing it from a company's balance sheet, large amounts of debt held by unconsolidated affiliates must raise concern that the company may be liable for the debts of the affiliated entities. There should have been suspicion as to why Enron was investing so much in unconsoli- dated entities SIGNAL #2: VAGUE REFERENCES TO UNCONSOLIDATED AFFILIATES IN NOTES TO THE FINANCIAL STATEMENTS Vague references in the notes to the financial statements or in the management discussion and analysis (MD&A), particularly regarding invest- ments in unconsolidated affiliates or off-balance-sheet entities, should be regarded as warning signals. Be very cautious when notes are unclear as to one or more of the following The nature of the transactions with the entity The reason for using the special entity, The name of the entity, The nature of the entity--whether it is a partnership, a trust, a joint venture, or an established corporation When investments in unconsolidated affiliates or related-party transactions occur with specially constructed entities such as partnerships, trusts, or joint ventures-as opposed to independently established companies-one should be on the alert that the company could be using SPEs to understate debt and boost earnings. The company also may be blending the disclosure of these SPEs with regular investments in indepen- dently established companies. Therefore, users of financial statements must be on high alert for unconsolidated affiliates that are described in vague terms. Unless a company operates in an industry where the use of SPES is widespread, the financial statements and the MD&A should make very clear the nature of the SPE, as well as the reason for its use. In an examination of the notes to Erron's financial statements, the following selec- tion of alerts was revealed: In 1998, Enron's consolidated balance sheet already showed a $4.433 billion invest ment in unconsolidated affiliates. In the related notes, the relationships between Enron and some of these affiliates were described briefly, whereas others were not named or described at all. In fact, $1.199 billion of the $4.433 billion was simply described as "other." The notes also stated, "From time to time, Enron has entered into various administrative service, management, construction, supply and oper- ating agreements with its unconsolidated affiliates." In the 1998 Annual Report, the note titled "Merchant Assets" stated, "The invest- ments made by Enron included public and private equity, debt, production pay- ments and interests in limited partnerships." (Emphasis added.) In the 1999 annual financial statements, several of the LJM SPEs are mentioned in the notes under "Related Party Transactions" without using the term special purpose entities. It becomes clear that Enron's own stock was invested in these part- nerships from the statement: "LJM received $6.8 million shares of Enron common stock Also in the 1999 notes to the financial statements, an alarming number of new affiliates were added to the list of "Unconsolidated Equity Affiliates," including the now infamous Whitewing structure that hid enormous debt and losses from Enron's financial statements. Vague descriptions were given of the Whitewing structure without a clear rationale for its existence in the first place (The LJM structure of unconsolidated entities was not even listed in the unconsolidated affiliates' note, although it was mentioned under "Related-Party Transactions.") In 2000, the "Unconsolidated Affiliates" note provided an incomplete list of entities, and although some significant SPEs were omitted, the note did men- tion the sale of Enron's merchant assets to Whitewing. This piece of information sheds some light on why the entity was created in the first place and why it was shrouded in vagueness in the financial reports. Enron was selling its own assets to this affiliated entity. Why would it do that? No rationale was given. (In the previous year, sales of merchant assets to Whitewing had not been mentioned in Enron's unconsolidated affiliates' note concering Whitewing.) By the time Enron's 2000 Annual Report was issued, investors should have been aware of Enron's investments in the partnerships and joint venture entities of Whitewing, LJM, and JEDI, and they should have realized that it was undear as to why and how these entities were being used. This level of vagueness about off- balance sheet entities should have been a strong alert that Enron may have been concealing something SIGNAL #3: UNCONSOLIDATED AFFILIATES USED TO GENERATE SIGNIFICANT PROFITS When unconsolidated affiliates--especially constructed entities such as partnerships--are used to generate a significant portion of a company's profit, it is a signal that the company may be using SPEs to manipulate its financial statements A company could be using the SPEs to move poorly performing assets off its financial statements to avoid dilution of reported earnings or to generate gains. It is therefore important to search the notes to the financial statements for "gains" or profits eamed outside of regular operations, especially where such gains appear to have been made in connection with unconsolidated affiliates of the company. In Enron's case, an examination of the "Merchant Investments" notes and "Merchant Activities" notes in its annual reports revealed important information regarding the sales of Enron's merchant assets. Refer to Table 7.1 for Enron's pretax gains on sales of merchant assets from 1997 to 2000. Table 72 presents the calculation of Enron's "Pretax Gains on Sales of Merchant Assets" as a percentage of "Operating Income." It is mind boggling to discover that in 1997, without these gains on sales of mer- chant assets, Enron's consolidated operating income of $15 million would have been an operating loss of $121 million. It is even more alarming because the "Merchant Investment" note in 1998 shows that the majority of the merchant investments, total- ing $1859 billion, were held through unconsolidated affiliates, including partnerships. TABLE 7.1 Enron's Pretax Gains on Sales of Merchant Assets Year Amount 1997 $136 M. 1998 5628 M 1999 $756 M 2000 5104 M Derived from Enron's Notes to the Consolidated Financial Statements TABLE 12 Enron's Pretax Gains on Sales of Merchant Assets and Investments as a Percentage of Operating Income Year Percentage 1997 906% 1998 46% 1999 94% 2000 5% Derived from Enron's Notes to the Financial Statements Therefore, without these transactions with unconsolidated entities, a significant portion of Enron's "profits" would not have existed. Certainly, examining the income statement on the basis of normal, regular oper- ating profit, one had to consider whether Enron stock had a value anywhere near the price at which it was trading Ultimately, of course, it tumed out that Enron was virtu- ally worthless SIGNAL #4: RELATED PARTY TRANSACTIONS NOTE TO THE FINANCIAL STATEMENTS REFERRING TO TRANSACTIONS WITH UNCONSOLIDATED SPES When the note to the financial statements on "Related Party Transactions" refers to transactions with uncon- solidated affiliates, especially specifically constructed entities, such as partnerships or trusts, it is a signal that the company may be using the SPEs to hide debt or generate fictitious profits Enron's "Related-Party Transactions" note to the financial statements in its 1999 Annual Report stated, "A senior officer of Enron is the managing member of LIM's gen- eral partner Furthermore, it explained that "LJM2, which has the same general partner as LM, acquired, directly or indirectly approximately $360 million of merchant assets from Enron, in which Enron recognized pretax gains of approximately $16 million." Although the term special purpose entity was not used in this note, the waming signs were unmistakable An Enron officer was doing business with Enron for an Enon-constructed entity in a potential conflict of interest with Enron. Enron was selling its assets to itselt The same note to the 1999 Annual Report also revealed that "Whitewing acquired S192 million of merchant assets from Enron. Enron recognized no gains or losses in connection with these transactions." Whitewing was another unconsolidated Enron entity, and here again, Enron was doing transactions with itself and moving assets to this structure in such a case, one had to wonder whether the reason for this was to avoid recording large losses In the 2000 Annual Report the "Related-Party Transactions" note referred to a "Related Party that "acquired approximately $371 million of merchant assets and investments and other assets from Enron" in 2000. That same Annual Report revealed that Enron had expanded its investment in SPEs to an outrageous degree: "Enron Chapter 7 Enron and the Tale of the Golden Goose contributed to newly formed entities (the Entities) assets valued at approximately $1.2 billion, including $150 million in Enron notes payableand] 3.7 million restricted shares of outstanding Enron stock." Although Enron was not forthcoming about the fact that it was moving losing assets to these SPEs at values that hid the losses, the mere disclosure of the magnitude of the transactions-together with the involvement of Enron officials in the SPEs trans- actions with Enron-should have alerted interested parties to the following There was the opportunity for hiding losses in these transactions . There was no reliable market price for the sale of the assets There was no objective way of calculating Enron's real profit Interested parties had to blindly trust Enron and Enron's external auditor, Arthur Andersen, concerning the validity of the prices used for the related party transactions SIGNAL #S: SECURITIZATION OF CURRENT ASSETS Securitizations by nonfinancial insti- tutions of current assets-whether accounts receivable or financial instrument assets indicate that a company may be experiencing cash-flow problems and that it needs to accelerate the realization (or liquidation) of an asset into cash faster than the asset would be liquidated in the ordinary course of business To test for an indication of a fictitious receivable, one should add the amount of the securitization--the cash received by selling a receivable that would normally be paid to the company later-back to the receivables (accounts receivable or, in Enron's case, "assets from price risk management activities") before calculating the ratio of the receivables-to-sales. By the same logic, to test for an indication of overstated income that is not being realized in the form of CFFO, one should deduct the amount of the securitization from CFFO before calculating the ratio of operating income or net income to CFFO. In Enron's annual financial statements for 2000, the note titled "Price Risk Management Activities and Financial Instruments contained a subsection identified as "Securitizations," which stated, "During 2000, gains from sales representing securitiza- tions were $381 million and proceeds were $2,379 million (5545 million of the proceeds related to sales to Whitewing Associates LP.)." This meant that close to half of Enron's CFFO came from securitizations of its current assets. Further, part of the securitiza- tion included a related-party transaction with an off-balance sheet partnership entity (Whitewing) It is time to sit up and become suspicious when a review of financial statement notes reveals the following A company invests significant amounts in unconsolidated SPES. . That company engages in significant related-party transactions with these entities. The transactions include significant securitizations or sales of current assets to accelerate cash collections These are clear indications that a company may be sprucing up its reported finan- cial statements-and that one cannot rely on the financial statements for analyzing the profit, the cash-flow generation, or the debt of the company (As a case in point, the securitizations signal for Xerox, as discussed in Chapter 4 "Hocus Pocus," indicated the importance of adjusting ratios to test the validity of accounts receivable and CFFO. This is done by adding back the securitized amount to accounts receivable and deducting the securitized amount from CFFO. With Xerox, the CFFO as adjusted for the "sold receivables" revealed that the amount by which CFFO lagged operating income was quite alarming.) In Enron's case, the securitizations occurred together with references to related- party transactions, specially constructed entities, and sales where some ownership interests in the "sold" assets were retained by Enron. That combination of factors was more than a signal, it was a siren. It is important to search the 10-ks and 10-Qs, and to pay attention to notes to the financial statements, and to look for the words securiti- zation and factoring and for the phrase sales of accounts receivable to pick up this accelera- tion of cash flow SIGNAL #6: RETAINING PARTIAL OWNERSHIP IN ASSETS SOLD When a company has sales in which it retains any of the ownership interests in the asset sold, it is a signal that the company may actually be obtaining a loan and classifying it as a sale When such transactions involve off-balance-sheet entities, it is especially trou- bling In Enron's 1998 Annual Report, the note titled "Merchant Activities" stated, "Some of these sales are completed in securitizations in which Enron retains certain interests through swaps associated with the underlying assets." We now know that many of these sales were, in fact, disguised loans in which the "certain interests" that Enron retained were the ownership interests, meaning that the sales" were actually loans. Further, the profit or gains on these so-called sales were included in operating income SIGNAL #7: A COMPANY GUARANTEEING THE DEBT OF ITS SPES When a company guar- antees the debt of its unconsolidated (off-balance sheet) entities, it is a signal that these entities are being used to raise debt and hide the debt by keeping it off the company's own balance sheet and the group's consolidated balance sheet. In Enron's 1998 Annual Report, there is a note to the financial statements titled "Commitments." According to this note: Enron also guarantees the performance of certain of its unconsolidated affiliates in connection with letters of credit issued on behalf of those unconsolidated affiliates. At December 31, 1998, a total of $209 million of such guarantees were outstand- ing. In addition, Enron is a guarantor on certain liabilities of unconsolidated affiliates and other companies totaling approximately $755 million The growth of Enron's guaranteed liabilities over the three-year period from 1998 to 2000 was quite staggering, as can been seen from Table 73. TABLE 7.3 Guaranteed Liabilities Extracted from Notes to Enron's Annual Reports: 1998-2000 December 1998 December 1999 $ 303 M December 2000 $209 M $ 264 M Guaranteed Liabilities for Letters of Credit on behalf of unconsolidated affiliates Guaranteed abilities on behalf of certain liabilities of unconsolidated affiliates and other companies 5755 M $1,501 M $1,863 M M-million Although Enron did not fully disclose all the guarantees or the fact that it was likely the entities would default and that Enron itself would be liable for the guaranteed amounts, these notes were unmistakable red flags due to the magnitude of Enron's unconsolidated affiliates and its related-party transactions with them. The combination of these signals indicated that the off-balance sheet activity was sufficiently significant as to render the published balance sheet wholly inadequate for analysis of the company. Indeed, we now know that the guarantees relating to special purpose unconsolidated entities actually bankrupted Enron within one year of the issue of its 2000 Annual Report. CASE STUDY BASIN WATER. INC*. Examine extracts from the selected financial statements from Basin Water, Inc., for the fiscal years ended 2005, 2006, and 2007. Examine Note 9 and Note 15 to Basin Water's Consolidated Financial Statements for 2007. Respond to the following Case Study questions. Required . a. Improper Use of SPEs: The SEC's Complaint (2011) against Basin Water, Inc. alleged: "The Defendants Materially Overstate Basin's Q2 2007 And Year-To-Date Revenues By Engaging In A Sham $3.8 Million Sale To A Special Purpose Entity They Directly Or Indirectly Cause To Be Created" (section F). After review- ing the signals for Enron's schemes of using SPEs to understate debt and to overstate earnings, identify the signals of the improper use of unconsolidated affiliates, or SPEs, that were present in the Enron case and can allegedly be found in Basin Water's notes to its financial statements. Explain why those signals could have been indica- tions that Basin Water may have alleg- edly overstated its sales and under- stated its loss. Extracts from FORM 10-K Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the fiscal year ended September 31, 2006 BASIN WATER, INC. Balance Sheets in thousands except share and per share data) December 31, December 31, 2006 2005 ASSETS Current assets Cash and cash equivalents $ 54,567 5 2.724 Accounts receivable, net of 567 and 50 allowance for doubtful accounts 2416 3.927 Unbiled receivables, net of 5433 and 50 allowance for doubtful accounts 9,123 3,123 Inventory 714 347 Prepad expenses and other 634 189 Notes recewable 100 Total current assets 67454 10.410 Property and equipment Property and equipment 13,521 10.445 Less accumulated depreciation 1,394 962 Property and equipment, net 12227 9.483 Other assets Long-term unbiled receivables 7.466 2.744 Patent costs, net 383 286 Loan costs, net 37 Other assets, net 2.485 Total other assets 10371 3.905 Total assets 590052 23 299 UABILITIES AND STOCKHOLDERS' EQUITY Current liabilities Accounts payable $ 15625 2,150 Current portion of notes payable 2.007 674 Current portion of capital lease obligations 17 15 Current portion of deferred revenue and advances 292 741 Current portion of contract loss reserve 1321 Accrued expenses and other 2.291 273 Total current liabilities 7490 3,853 (continued * Extracted from 16-K filings for Basin Water, Inc. 2005-2007 Obtained from US Securities and Exchange BODO 286 Chapter 7. Enron and the Tale of the Golden Goose December 31, December 31, 2006 2005 10 6,878 24 40 387 439 2,404 2.250 6,529 10,315 19,989 Notes payable, net of current portion and unamortized discount Capital lease obligations, net of current portion Deferred revenue, net of current portion Contract loss reserve, net of current portion Redeemable convertible Series A preferred stock, no par value-6,000,000 shares authorized, 0 and 627 500 shares issued and outstanding Redeemable convertible Senes B preferred stock, no par value5,000,000 shares authorized, 0 and 1.734, 125 shares issued and outstanding Total liabilities Commitments and contingencies Stockholders' equity Common stock, no par value40,000,000 shares authorized, 10,303,047 shares issued and outstanding Common stock, 50.001 par value-100,000,000 shares authorized 19,887,672 shares issued and outstanding Additional paid-in capital Accumulated deficiency Total stockholders' equity Total liabilities and stockholders' equity 7.927 20 95,002 (15.285) 79,737 $ 90,052 (4,118) 3.809 $ 23,798 Extracts from FORM 10-K For the fiscal year ended December 31, 2007 BASIN WATER, INC. Consolidated Balance Sheets (in thousands, except share and per share data) December 31, December 31, 2007 2006 ASSETS Current assets Cash and cash equivalents 5 35,456 $ 54,567 Accounts receivable, net of 572 and 567 allowance for doubtful accounts 3,167 2,416 Unbilled recewables, net of 5524 and 5433 allowance for doubtful 11.443 9,123 accounts Inventory 1,055 714 Current portion of notes receivable 338 Prepaid expenses and other 1.233 Total current assets 52,692 67.454 Property and equipment Property and equipment 15,945 13,621 Less accumulated depreciation 1.645 1,394 Property and equipment net 14,300 12,227 (continued Extracted from 10-K filings for Busin Water, Inc. Obtained from US Securities and Exchange Commission www.secgo December 31, December 31, 2007 2006 7466 8,682 7,664 1,015 3,416 2.2 74 4,502 1,667 31.220 $98 212 1.641 383 881 10.371 590052 53.553 Other assets Goodwill Unbiled receivables, net of current portion Notes recevable, net of current portion Intangible assets, net Patent costs, net Investment in affiliate Other assets Total other assets Total assets UABILITIES AND STOCKHOLDERS' EQUITY Current liabilities Accounts payabile Current portion of notes payable Current portion of capital lease obligations Current portion of deferred revenue and advances Current portion of contra los reserve Accrued expenses and other Total current liabilities Notes payable, net of current portion Capital lease obligations, netof current portion Deferred revenue, net of current portion Deferred revenue aflate Contract loss reserve, netof current portion Deferred income tax liability Other long-term liabilities Total liabilities Commitments and contingencies Stockholders' equity Common stock, SO 001 par value-100,000,000 shares authorized, 21.948,704 and 19,887672 shares sued and outstanding Additional paid capital Treasury stock Acumulated deficiency Total stockholders equity Total liabilities and stockholders' equity 266 1964 3,140 5 1562 2.007 17 292 1.321 2.291 7,490 10 8.934 15 387 2.404 296 1.920 5311 2.268 179 18923 10315 22 20 95.002 110.354 (552) 30 535) 79 289 598212 (15.285) 79,737 5.90 052 The accompanying notes are an integral part of these consolidated financial statements Basin Water, Inc. Consolidated Balance Sheets in thousands, except per share data) Years Ended December 31, 2007 2006 2005 $ 13,477 $ 13,861 5 10,016 5,307 3,253 2.215 18,784 17,114 12,231 13.790 10,698 443 24,931 (6,147) 564 13,685 (20,396) 12,161 7,522 423 20.106 (2.992) 634 6,827 (10,453) 4,467 2,323 340 7.130 5.101 651 3,334 1.116 Revenues System sales Contract revenues Total revenues Cost of revenues Cost of syster sales Cost of contract revenues Depreciation expense Total cost of revenues Gross profit (loss) Research and development expense Selling, general and administrative expense Income (loss) from operations Other income (expense) Interest expense Interest income Gain on sale to affiliate Other income Total other income (expense) Income (loss) before taxes Income tax benefit Net income (loss) Net Income (loss) per share: Basic Diluted Weighted average common shares outstanding: Basic Diluted (621) 52 (98) (2.781) 2.736 2,061 2,500 8 6 5,146 (714) (15,250) (11,167) 16 (553) 563 5 (15,250) 5 (11,167) S 563 S (0.76) S (0.70) S 0.06 5 (0.76) S (070) 5 0.04 20.185 20,185 16,048 16,048 9,924 12,849 Basin Water, Inc Consolidated Statements of Cash Flows an thousands) Years Ended December 31, 2007 2006 2005 5 (15,250) 5 (11,167) 5563 Cash flows from operating activities Net income (loss) Adjustments to reconcle net loss to net cash provided by operating activities Depreciation and amortization Stock-based compensation expense Gain on sale to affiliate ksuance of warrants for services Wnite off of loan acquisition costs 995 1,706 (2.500) 1,024 744 506 31 417 34 401 - (continued) Chapter 7 Enron and the Tale of the Golden Goose Years Ended December 31, 2007 2006 2005 (1,817) (4,489) 103 (367) (542) (445) 1.600 (588) (117) (501) (1,515) 2,018 3,550 3,725 4,091 636 (3,353) (207) (3386) (13,256) (12,361) (6,279) (268) (80) 1,468 354) 397 (2.810) (6.409) (5,347) (6,214) (3,942) (1.913) Changes in operating assets and abilities Accounts receivable induding unbilled Inventory Prepaid expenses and other Accounts payable Deferred revenues Accrued expenses and other Contract loss reserve Net book value of systems sold Issuance of notes receivable Other assets and other liabilities Net cash used in operating activities Cash flows from investing activities Purchase of property, plant and equipment Acquisition of business, net of cash acquired Collection of notes receivable Patent costs Net cash used in investing activities Cash flows from financing activities Issuance of common stock Repurchase of common stock Proceeds from employee stock option exercises Proceeds from warrant exerases Issuance of redeemable preferred stock Proceeds from notes payable Loan origination fees Repayments of notes payable and capital lease obligations Net cash provided by financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents, beginning of period Cash and cash equivalents, end of period 100 (99) (31) (11,592) 325 (107) (1,695) (3,941) 75,178 3,584 (552) 527 162 8,060 596 2.000 5,156 (100) (100) (2,298) (9,095) (112) 5.737 68,145 9,124 (19,111) 51,843 1,020 54,567 2,724 1,704 $ 35,456 $ 54,567 5 2.724 From Basin's 10-K 2007 NOTES, Pages F20-722 Note 9: OTHER ASSETS Goodwill The table below summarizes the changes in the carrying amount of goodwill for the year ended December 31, 2007 Balance at December 31, 2006 5 Acquisition of business during the period 8,682 Balance at December 31, 2007 58,62 Long-term Accounts Receivable and Notes Receivable The Company has four cus tomer system sales agreements which provide for payment terms ranging from two to five years, unless certain conditions are met, in which case the payment terms are accelerated. At December 31, 2007 and 2006, the amount of long-term accounts receiv- able was $7,661 and $7,466, respectively, which represents the balance due from these four customers under the extended payment terms. In 2004, in connection with the sale of a system, the Company received a $300 unse- cured note that provides for interest at a rate of 3% per annum. The Company received a payment of $200 in connection with this note in 2005. The final principal payment of $100 became due in 2006, and as such, the note has been classified as current. The Company has reserved $67 of this note as of December 31, 2007 and 2006. Both the note and the related allowance for doubtful accounts have been classified as current assets and are included in the accounts receivable balance at December 31, 2007 and 2006. At December 31, 2007, long-term notes receivable consist of non-interest bear- ing notes receivable from VL Capital, due in 72 monthly installments of $63 beginning April 2008, with a net present value of $3,353, calculated using an imputed interest rate of 5.0% per annum Intangible Assets Net intangible assets are as shown in the following table as of the dates indicated December 31, 2007 2006 Deferred stock based compensation 5189 $ 394 Fair value of warrants, net 916 1.210 Service agreements and contracts 1.299 Customer relationships 560 Covenant not to compete 295 Trade game 157 Loan costs, net 37 Intangible assets, net $3,416 51 641 The amortization period of intangible assets are as follows: customer relationships-15 years, covenant not to compete--three years, trade name-two years, service agreements and contractssix years, deferred stock-based compensation- three years, and fair value of warrants issued to a joint venture partner-five years. Patent Costs The Company capitalizes costs of patent applications. As a result of the September 2007 acquisition of MPT, the Company recorded an additional $1812 repre- senting the fair value of patents acquired. When patents are issued, the Company amor tizes the patent cost over the life of the patent, usually 17 years. Future amortization of patent costs at December 31, 2007 is approximately $107 per year for each of the five years ended December 31, 2008 through 2013, and $107 each year thereafter through 2024. If a patent is denied, capitalized patent costs are written off in the period in which a patent application is denied. Investment in Empire Water Corporation (Empire) In May 2007, the Company entered into an agreement to acquire certain water rights and related assets. In December 2007, the Company sold its rights to purchase these assets to Empire. As consideration for the sale of these assets, the Company received 6,000,000 shares of Empire common stock, which represents an ownership interest of approximately 32% in Empire as of December 31, 2007 The Company accounted for the December 2007 transaction under the equity method. Specifically, the Company recorded $2,500 as gain on sale to affiliate upon the receipt of the shares of Empire common stock by estimating the fair value of such stock based upon concurrent sales of Empire common stock to third parties, and reducing the fair value by the Company's ownership interest in Empire. This reduction of approx mately $1,900 has been recorded as deferred revenue-affiliate on the balance sheet of the Company at December 31, 2007 The Company has recorded its investment in Empire at approximately $4,500, while the amount of underlying equity in the net assets of Empire is approdimately $3.000. The dif ference of approximately $1 500 represents the excess of the market value of the Company's investment in Empire over the Company's 32% interest in the net assets of Empire The following tables present summarized information concerning the assets, liabilities and results of operations of Empire for the most recent periods for which information is available: Assets Labilities Dec 31, 2007 $9450 $ 101 Six Months Ended Dec 31, 2007 5 Year Ended June 30, 2007 5 33 Revenues et loss From BASIN's 10-K 2007 NOTES, Page 27 Note 15: RELATED PARTY TRANSACTIONS The Company paid legal fees to a legal firm whose partner is a director. The total payments for legal fees to this firm were $315, $192 and $154 for the years ended December 31, 2007, 2006 and 2005, respectively The Company also leases office space and equipment from two individuals, one of whom is a director and employee and the other an employee, under month-to-month agreements. The total payments under these related party rental agreements were $57. $54 and 555 for the years ended December 31, 2007, 2006, and 2005, respectively In May 2007, the Company entered into an agreement to acquire certain water rights and related assets. In December 2007, the Company sold its rights to purchase these assets to Empire. As consideration for the sale of these assets, the Company received 6,000,000 shares of Empire common stock, which represents an ownership interest of approximately 32% in Empire as of December 31, 2007 The Company accounted for the December 2007 transaction under the equity method. Specifically, the Company recorded $2,500 as gain on sale to affiliate upon the receipt of the shares of Empire common stock by estimating the fair value of such stock based upon concurrent sales of Empire common stock to third parties, and reducing the fair value by the Company's ownership interest in Empire In addition, Empire agreed to purchase one water treatment system from the Company concurrent with the December 2007 closing for a total price of $900. During the year ended December 31, 2007, the Company recorded $653 of system sales rev- cue and $287 of gross margin on this transaction under the percentage-of-completion method of revenue recognition. The Company has recorded $92 as a charge against other income under the equity method, which represents 32% of the Company's gross margin on this system sale to a related party. SIGNALS OF THE ENRON FRAUDS A number of red flags in Enron's financial statements indicated that Enron had been using off-balance sheet entities or SPEs to understate debt and overstate earnings. Signals of Enron's Fictitious Reporting Schemes of Using SPEs (or Unconsolidated Affiliates) to Understate Debt and Overstate Earnings Because SPEs are usually equity investments-investments in which the investor acquires an ownership interest in the investeethe information about SPEs is often included but hidden among the other equity investments on the investor's balance sheet. Generally, equity investments in companies fall into one of three categories: 1. Holdings of less than 20 percent, where the investor has a passive interest in the investee. The investee's assets and liabilities are not consolidated into the inves- tor's group balance sheet. Income is recognized when dividends are declared. 2. Holdings of between 20 percent and 50 percent, where the investor is deemed to have significant influence, but not control, unless information to the contrary exists. These investments are often classified as "investments in unconsolidated affiliates" on the balance sheet. The assets and liabilities of the affiliate are not consolidated into the investor's group balance sheet. The investor accounts for its share of the investee's income using the equity method. 3. Holdings of more than 50 percent of the equity of the investee, where the investee is deemed to have a controlling interest. The investee's financial statements are consolidated into the investor's group financial statements. The three categories become blurred, however, when investors or sponsors create SPES. SPEs are usually "created by a party (the transferor or the sponsor) by transfer- ring assets to another party (the SPE) to carry out a specific purpose, activity or series of transactions. Such entities have no purpose other than the transactions for which they were created" (Soroosh & Ciesielski, 2004). They are often partnerships, joint ventures, or trusts, and sometimes they are corporations. In pre-Enron accounting, because such entities operate for a specific purpose, the Emerging Issue Task Force (EITF 90-15) allowed SPEs to be excluded from consolidation with the sponsor's group financial statements "as long as the equity interest of a third- party owner was at least 3% of the SPE's total capitalization, the same time, the major- ity of equity voting rights cannot reside with the beneficiary" (Soroosh & Ciesielski, 2004). Many companies began to bend the rules and create entities over which they had control, in which they had invested most of the equity capital (except for 3 percent), and for which they had further obligations for the entities' debt. They used the non- consolidation rule to avoid including such SPES' debt in their balance sheets and to avoid eliminating profit on related-party transactions with these entities. These invest- ments in off-balance-sheet entities were often lost or hidden in the investor's balance sheets as though they were typical investments in unconsolidated affiliates where the investor holds between 20 percent and 50 percent of the investee. As previously mentioned, post Enron, accounting for SPEs was updated by the Financial Accounting Standards Board Interpretation FIN 46 (R) as amended by FASB No. 167 (2009). The latest guidance for consolidation is the ASC 610 proposed update issued in 2011. The Board estimates a final update will be issued in the second half of Chapter 7 Enron and the Tale of the Golden Goose 2014. In essence, under FIN 46(R), if a sponsoring company has an investment in an entity that is not self-supportive and there is a possibility that the investor may need to provide further financial support, the investee must be defined as a variable interest entity (VIE) VIEs must be consolidated into a company's group financial statements if the company is a primary beneficiary of the VIE The FASB Summary of Statement No. 167 (2009) identifies the primary beneficiary as: [T]he enterprise that has both the following characteristics: 1. The power to direct the activities of a variable interest entity that most signifi- cantly impact the entity's economic performance 2. The obligation to absorb losses of the entity that could potentially be significant to the variable interest entity or the right to receive benefits from the entity that could potentially be significant to the variable interest entity In addition, disclosure is also required in the MD&A section regarding certain details of off-balance sheet arrangements. The proposed accounting standards update ASC 810,"provides criteria for a reporting entity to evaluate whether a decision maker is using its power as a principal or an agent . These criteria would affect the evaluation whether an entity is a variable interest entity and, if so, whether the reporting entity should consolidate the entity being evaluated" (FASB News Release, Nov. 2011). It is important to note that pre-Enron accounting rules also required many of Enron's unconsolidated SPEs to be consolidated into Enron's financial statements, but Enron - failed to consolidate many of its now infamous SPES. If some companies broke the old rules requiring certain off-balance-sheet entities to be consolidated, some will likely be tempted to break the new rules as well. Therefore, hints in financial statements and notes are instructive for telltale signs of problematic SPES. Enron's SPEs were hidden mainly among its investments in unconsolidated affili- ates and other investments. Hints were left in references in the notes to the financial statements regarding unconsolidated affiliates and also in the notes regarding related- party transactions, guarantees, and sales" where some ownership rights in the "sold assets" were retained by the seller. There were also vague references, in notes to the financial statements, to investments in partnerships and trusts and the financing of such entities with Enron's own stock. SIGNAL #1: ASSETS AND LIABILITIES OF UNCONSOLIDATED AFFILIATES OR SPES INCREASING SIGNIFICANTLY When the amount of the assets and liabilities of unconsol- idated affiliates or SPEs grows si