FIN540-Week-2-Discussion-2

“Leasing” Please respond to the following:

Contrast an operating lease, a sale-leaseback, and a capital lease. Imagine that you are about to start your own business. Determine whether you would buy or lease your long- term assets. Provide a rationale for your response.

Discuss the role of Special Purpose Entities (SPEs) in the fall of Enron. Examine the method in which Enron used SPEs to hide its liabilities. Determine the key reasons why accountants, investors, and creditors found it challenging to determine the real assets and liabilities of the company.

ANSWER:

“Leasing” Please respond to the following:

Contrast an operating lease, a sale-leaseback, and a capital lease. Imagine that you are about to start your own business. Determine whether you would buy or lease your long- term assets. Provide a rationale for your response.

Operating lease – Is typically for assets that have longer life cycles. The lessor ordinarily does not recover the cost during the first short contract, but rather expects to rent the asset for the life-span of multiple contracts. These leases typically include maintenance and include a cancellation clause, making them attractive to the average lessee.

Sale-and-Leaseback arrangement – This is similar to a mortgage loan in that the company sells land, buildings or equipment, only to make regular lease payments to continue using it. This lease arrangement provides the investor with the original purchase price and an agreed upon return or ‘interest’.

Capital lease – In contrast to an operating lease, the capital lease does not provide maintenance, the contract is not cancellable, and the lessor receives payments equal to the purchase price plus a return. This allows the company to begin using the equipment immediately while making standard recurring payments. The return on this lease for the lessor is approximately equal to the interest rate of a standard loan.

The operating lease is the most attractive, since you have the ability to cancel at any time. In addition, this type of lease is cheaper because it includes maintenance and does not provide the lessor with a return above the purchase price. If I had the cash to purchase myself, the operating lease still seems like a better option, since I can cancel at any time. The company’s operations could change and the operating lease provides the flexibility needed to adapt. Although I wouldn’t make them my first choice, the Sales-and Leaseback and Capital leases also have advantages. For example, my company’s financial statements wouldn’t be burdened by the depreciating asset values and the federal taxes related to asset values.

Discuss the role of Special Purpose Entities (SPEs) in the fall of Enron. Examine the method in which Enron used SPEs to hide its liabilities. Determine the key reasons why accountants, investors, and creditors found it challenging to determine the real assets and liabilities of the company.

Since the 1970s Special Purpose Entitie (SPE) transactions provided a specific and legitimate purpose for corporations: isolating financial risk and providing less-expensive financing. In historical practice, because SPEs do not engage in business other than the ones for which they are created, and their activities are backed by their corporate sponsors, they are able to raise funds at lower interest rates than those available to their parent company. Enron used these off-balance sheet arrangements for more devious purposes.

Enron’s demise began when investors became aware of subsidiary companies created solely to hide large liabilities for the corporation. In reality, Enron had created around 500 such Special Purpose Entities (SPE) to deceive shareholders by hiding the parent corporation’s liabilities and creating additional income (when no wealth actually existed), both of which made the preparation and publishing of high performing financial statements possible (Reinstein & Weirich, 2002). A diagram of transactions relative to one such SPE, Chewco Investments L.P., originally provided by Enron Board of Directors member and Chairman of the Special Investigation Committee (2001), William Powers, provides an illustration:

The initial publicity of these facts soon made Enron stock worthless and damaged the confidence of investors, having a far reaching impact on the stock market as a whole. Faced with both a Securities and Exchange Commission and Congress investigation, along with numerous angry shareholders, Enron soon filed for bankruptcy and closed its doors. Former CEO Jeffrey Skilling was eventually convicted on 19 counts, including money laundering, bank fraud, insider trading and conspiracy, and sentenced to over 24 years in prison (Forbes, 2013). Kenneth Lay was eventually convicted on 6 counts of fraud and faced up to 45 years in prison, but passed away in 2006 before the final sentencing hearing (Forbes, 2013).

Ehrhardt, M., Brigham, E., & Daves, P. (2013). Advanced Corporate Finance (14th ed.). Mason, OH: Cengage Learning.

Forbes. (2013, February 5). 5 Most Publicized Ethics Violations by CEOs [Web log post]. Retrieved from http://www.forbes.com/sites/investopedia/2013/02/05/5-most-publicized-ethics-violations-by-ceos/Reinstein, A., & Weirich, T. R. (2002). accounting issues at enron. CPA Journal, 72(12), 20. Retrieved from Strayer University EBSCOHost database: https://search-ebscohost-com.libdatab.strayer.edu/login.aspx?direct=true&db=bth&AN=8735560&site=ehost-live&scope=siteSpecial Investigative Committee of the Board of Directors of Enron Corp. (2001). Report of Investigation. Retrieved from the CNN website: http://i.cnn.net/cnn/2002/LAW/02/02/enron.report/powers.report.pdf