In substance defeasance

What Is In-Substance Defeasance?

In-substance defeasance is an accounting technique within the broader category of financial accounting where a company effectively removes a long-term liability, typically debt, from its balance sheet by placing sufficient risk-free securities into an irrevocable trust. The cash flows from these securities are structured to precisely match the principal and interest payments of the debt. Despite the debt being removed from the balance sheet, the original debtor is not legally released from its primary obligation to the creditor. This accounting treatment allows companies to improve their reported financial statements without actually retiring the debt.

History and Origin

The concept of in-substance defeasance gained significant attention in the early 1980s. A notable instance occurred in 1982 when Exxon Corporation utilized this technique to remove over $500 million in debt from its balance sheet, resulting in a reported after-tax gain of $130 million. Exxon achieved this by depositing U.S. government securities into an irrevocable trust, the proceeds of which were intended to cover the future principal and interest payments of the defeased debt. This move sparked considerable discussion and debate within the financial community and among accounting regulatory bodies²¹, ²².

The Financial Accounting Standards Board (FASB) subsequently addressed in-substance defeasance with the issuance of FASB Statement No. 76, "Extinguishment of Debt," in November 1983. This statement provided the accounting guidelines under which such transactions could be recognized. Although the Securities and Exchange Commission (SEC) had previously imposed a moratorium on the use of in-substance defeasance in August 1982 to allow FASB time to consider the matter, the accounting technique was ultimately approved by a narrow vote²⁰.

Key Takeaways

• In-substance defeasance is an accounting method where a debtor places assets into an irrevocable trust to cover a specific debt's future payments.
• The goal is to remove the debt from the company's balance sheet, improving its reported financial position.
• Crucially, the company remains legally liable for the debt, even though it's off the balance sheet for accounting purposes.
• This technique became codified in U.S. Generally Accepted Accounting Principles (GAAP) under FASB Statement No. 76, later integrated into ASC 405-20.
• It can generate a reported gain on the income statement if the cost of the assets placed in trust is less than the carrying value of the debt.

Formula and Calculation

While there isn't a direct "formula" for in-substance defeasance in the traditional sense, the accounting impact is derived from a comparison of the debt's carrying value and the cost of the assets used to defease it.

The gain or loss recognized upon in-substance defeasance is calculated as follows:

• Carrying Value of Debt: This refers to the book value of the debt on the company's balance sheet before the defeasance. It includes the principal amount adjusted for any unamortized premium or discount.
• Cost of Assets Placed in Trust: This is the fair value or acquisition cost of the risk-free securities (e.g., U.S. Treasury bonds) deposited into the irrevocable trust.

If the cost of the assets is less than the carrying value of the debt, a gain is recognized. Conversely, if the cost exceeds the carrying value, a loss is incurred.

Interpreting In-Substance Defeasance

Interpreting in-substance defeasance primarily involves understanding its impact on a company's financial statements and underlying financial health. When a company engages in in-substance defeasance, the debt is removed from the balance sheet, leading to a lower debt-to-equity ratio and seemingly improved financial leverage. This can make the company appear less risky and more attractive to investors and creditors.

However, a careful interpretation requires looking beyond the face of the balance sheet. Since the debtor is not legally released from its obligation, the debt technically still exists as a contingent liability. Analysts often scrutinize the notes to the financial statements for disclosures about such transactions to get a complete picture of the company's true obligations. The practice can influence metrics like earnings per share if a gain is recognized, potentially creating a distorted view of operational performance.

Hypothetical Example

Imagine "Company A" has long-term bonds outstanding with a face value of $100 million and a carrying value (including an unamortized premium) of $102 million. Due to rising interest rates, the present value of the future debt payments at current market rates is lower. Company A decides to perform an in-substance defeasance.

1. Trust Creation: Company A establishes an irrevocable trust.
2. Asset Purchase: Company A purchases U.S. Treasury bonds, which are considered risk-free securities, for $98 million and places them into the trust. The maturity and cash flows of these Treasury bonds are precisely aligned to cover all future principal and interest payments on the outstanding $100 million bonds.
3. Accounting Entry:
   • The $102 million debt is removed from Company A's balance sheet.
   • The $98 million in Treasury bonds are also removed (offset against the debt).
   • Company A recognizes a gain of $4 million ($102 million carrying value - $98 million cost of assets) on its income statement.

While Company A's balance sheet now shows $102 million less in liabilities, it remains legally responsible for the debt should the trust fail for any reason. The financial statements would disclose this in-substance defeasance.

Practical Applications

In-substance defeasance is primarily utilized by companies looking to manage their balance sheet and reported financial ratios. Key applications include:

• Balance Sheet Optimization: By removing debt, companies can improve their debt-to-equity ratios and other solvency metrics, potentially enhancing their credit ratings and perceived financial strength¹⁹.
• Earnings Management: If current interest rates are higher than the original debt's coupon rate, a company might be able to purchase the necessary risk-free securities for less than the debt's carrying value, resulting in a gain on the income statement¹⁸. This can boost reported earnings per share.
• Debt Covenant Compliance: Improving financial ratios through in-substance defeasance can help a company comply with debt covenants that might otherwise be breached.
• Alternative to Early Retirement: When a company wants to effectively "retire" debt but direct reacquisition is difficult (e.g., widely held bonds, high call premiums), in-substance defeasance offers an alternative without notifying bondholders¹⁷.

This accounting maneuver falls under the purview of financial accounting standards, specifically FASB Accounting Standards Codification (ASC) 405-20, which provides guidance on the extinguishment of liabilities¹⁶.

Limitations and Criticisms

Despite its perceived benefits, in-substance defeasance has faced significant criticism, primarily due to its nature as an accounting treatment rather than a legal discharge of liability.

A major criticism is that the practice can be seen as "window dressing" or "cosmetic accounting," as the company remains legally liable for the debt even after it's removed from the balance sheet¹⁴, ¹⁵. Critics argue that because the legal obligation to the bondholders still exists, the debt should logically remain on the financial statements until it is truly settled¹³. The creation of the irrevocable trust ensures timely servicing of the debt but does not eliminate the firm's ultimate responsibility¹².

Furthermore, while it can generate a reported gain, in-substance defeasance ties up cash that could otherwise be used for productive assets or other corporate purposes, potentially leading to adverse cash flow effects¹¹. The reported gain is often a "paper profit" rather than a real economic gain, especially if the company has to borrow at higher interest rates to fund the trust¹⁰. The Financial Accounting Standards Board (FASB) even included the issue in a 1991 discussion memorandum, indicating ongoing concerns about the practice⁹. Companies considering this strategy should be aware of the ongoing debate and potential scrutiny from financial analysts and regulators⁸.

In-Substance Defeasance vs. Legal Defeasance

While both in-substance defeasance and legal defeasance involve setting aside assets to cover future debt obligations, a crucial distinction lies in the legal release of the debtor.

In-substance defeasance, as outlined in ASC 405-20, does not meet the criteria for true debt extinguishment because the debtor is not legally released as the primary obligor⁶, ⁷. Legal defeasance, conversely, involves a legal discharge of the debt, often through a specific provision in the debt agreement or a judicial process. This fundamental difference in legal responsibility is key to understanding the two concepts.

FAQs

Q1: Why would a company choose in-substance defeasance instead of just paying off its debt?

A company might choose in-substance defeasance to improve its balance sheet and financial ratios without immediately spending the cash to legally retire the debt, especially if direct debt repurchase is impractical or costly. It can also create a reported gain if market interest rates are favorable⁵.

Q2: Is in-substance defeasance permitted under U.S. GAAP?

Yes, in-substance defeasance is permitted under U.S. Generally Accepted Accounting Principles (GAAP), specifically addressed in FASB Accounting Standards Codification (ASC) 405-20-55-3 to 55-4⁴. However, it's distinct from legal debt extinguishment, as the debtor is not legally released from its obligation³.

Q3: What kind of assets are typically placed in the trust for in-substance defeasance?

The assets placed in the irrevocable trust must be "essentially risk-free securities," such as U.S. Treasury bonds or other government securities. Their cash flows (principal and interest) must precisely match the scheduled payments of the debt being defeased².

Q4: Does in-substance defeasance affect a company's cash flow?

While it removes the debt from the balance sheet, in-substance defeasance does require the company to use cash to purchase the assets placed in the trust. This can have an adverse effect on immediate cash flow as a significant amount of cash becomes illiquid, tied up in the trust¹.