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?