Question

In mid-2000, Enron Corporation and Blockbuster (a division of Viacom) set up a pilot project, streaming videos to a few dozen apartments in Portland, Oregon, from servers set up in the basement of the building. With that tiny beginning, Enron opened up a partnership, called Braveheart, which later that year would pump $110 million of fair value accounting profit onto Enron’s books. Here’s how the deal worked:
• Enron signed a 20-year exclusive agreement with Blockbuster to provide on-demand videos over Enron’s broadband network. Enron’s CEO boasted the venture would be a “killer app” that would help create demand for Enron’s coast-to-coast fiber-optic network. Enron hoped to make millions of dollars off the deal.
• Enron then created a partnership called EBS Content Systems LLC—but known inside the company as Braveheart—whose purpose was to get someone to advance Enron the money it expected to make on the deal with Blockbuster. To capitalize Braveheart, a small amount of money came from outside investors while Enron contributed the Blockbuster agreement and lent the partnership some stock. Braveheart thus became one of Enron’s infamous off-balance-sheet entities: consolidation was not required by GAAP and Enron recorded the Braveheart capitalization as a financial asset called “Investment in EBS Content Systems.”
• Next, an outside investment bank gave Braveheart $115 million in return for a promise that most of the earnings from the Blockbuster deal would go directly to the bank. In essence, Braveheart “securitized” its future earnings from the Enron–Blockbuster venture by selling its rights to the future earnings stream to the investment bank. If the earnings were not enough for the bank to recoup its investment, Enron promised that it would repay the bank.
• Enron then “marked-to-market” its Braveheart investment—Braveheart now had millions in cash from the investment bank—and booked the $110 million fair value increase as profit. Enron did not count all $115 million because, under an accounting rule, it had to estimate the fair value of its guarantee to pay back the bank and reduce its Braveheart investment fair value estimate by that amount.
In the end, the Blockbuster venture never made it beyond the pilot stage before Enron pulled the plug. At its peak, the service was provided to a few thousand households in four cities.
Enron later reversed the entire $110 million of profits in 2001. Some Enron employees said that while the arrangement existed, it helped Enron executives hit earnings targets that served both to pump up the value of the company’s stock and to inflate their bonuses.

Required:
1. What features of the Braveheart structure enabled Enron to bolster its 2000 profits using fair value accounting?
2. Describe how someone might determine the bank guarantee’s fair value (estimated to be $5 million by Enron).
3. Suppose the fair value of the bank guarantee was estimated to be $100 million. What impact would this new fair value estimate have on the amount of profit to be recorded by Enron in 2000 on the Braveheart deal?
4. What steps might an auditor take to assess the reliability of Enron’s $5 million fair value estimate for the bank guarantee?



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  • CreatedSeptember 10, 2014
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