Amid this disarray, a simple question has to be asked: why are the activities and transactions of special purpose entities (SPEs), legal entities that run collateralized debt obligations (CDOs) and similar financial vehicles, not displayed on the financial reports of corporate America? These SPEs remain hidden from view and corporate disclosures about them mist like a Chicago fog.

Recall that Enron's episodes were sprinkled with many an SPE shenanigan. The old accounting rule said that if the SPE had at least 3 percent of its total capital from some outside source, then the business enterprise did not have to consolidate the SPE with its own affairs. While EITF 90-15 originally applied to certain leasing activities, business managers quickly applied it to all sorts of SPEs, and the Financial Accounting Standards Board and the Securities and Exchange Commission allowed them to do so. The threshold was so low that managers found it easy to keep SPE debt off the balance sheet and to make few disclosures.

Because of Enron, FASB finally updated the rules to require consolidation unless outsiders contributed at least 10 percent of the capital to the SPE and this capital is at risk. Funny, FASB sat on its collective backside for over a decade before it took action. It seems the board members are incapable of taking proactive steps in any area.

One of the criticisms was that 3 percent equity does not really put the equity at risk. While the 10 percent cutoff remains arbitrary, it clarifies the situation -- until the board muddied this clarity with some mystical, principles-based goobledy-gook. Many managers complained because they perceived that billions of dollars would be added to the corporate balance sheet. Apparently the appeals had some effect, for FASB modified the final rule. Interpretation No. 46R now states:

9. An equity investment at risk of less than 10 percent of the entity's total assets shall not be considered sufficient to permit the entity to finance its activities without subordinated financial support in addition to the equity investment unless the equity investment can be demonstrated to be sufficient. The demonstration that equity is sufficient may be based on either qualitative analysis or quantitative analysis or a combination of both. Qualitative assessments, including but not limited to the qualitative assessments described in paragraphs 9(a) and 9(b), will in some cases be conclusive in determining that the entity's equity at risk is sufficient. If, after diligent effort, a reasonable conclusion about the sufficiency of the entity's equity at risk cannot be reached based solely on qualitative considerations, the quantitative analyses implied by paragraph 9(c) should be made. In instances in which neither a qualitative assessment nor a quantitative assessment, taken alone, is conclusive, the determination of whether the equity at risk is sufficient shall be based on a combination of qualitative and quantitative analyses.

a. The entity has demonstrated that it can finance its activities without additional subordinated financial support.
b. The entity has at least as much equity invested as other entities that hold only similar assets of similar quality in similar amounts and operate with no additional subordinated financial support.
c. The amount of equity invested in the entity exceeds the estimate of the entity's expected losses based on reasonable quantitative evidence.

Note that the 10 percent threshold can be ignored under several scenarios using either quantitative or qualitative excuses. As I said in 2003, this rule or standard is suspect and board members are spineless. The debt of an SPE is similar to the debt of a subsidiary. If FASB thinks that SPE debt does not have to be consolidated, it might as well announce that parent companies no longer have to show the liabilities of their subsidiaries.

We can forget substance over form. While we are at it, we might as well toss out decision usefulness and relevance because FASB really doesn't promote these ideals, despite the rhetoric in the so-called conceptual framework.

Given the ethical failures of both managers and auditors, I predicted in Hidden Financial Risk (2003) that many SPEs would remain unconsolidated. Indeed the majority of SPEs not only remain unconsolidated, but also the sponsoring organizations provide precious little disclosures about them. With the help of investment bankers, corporate managers have been highly creative in finding rhetoric that skirts principled accounting. When the corporate executives are managers of the investment banks, well, the creativity is off the charts.

Years ago FASB and the SEC should have required the consolidation of SPEs. The last six months or so have clearly displayed the need for improved corporate reporting. This directive applies to the sponsors of CDOs including Citicorp and Merrill Lynch: they should consolidate their special purpose vehicles.

How many more debacles in the market place will occur before FASB and the SEC get it right? When will they have men and women of courage?

This essay reflects the opinion of the author and not necessarily the opinion of The Pennsylvania State University.