In Substance Defeasance

Meaning

It comprises of two words, namely “In substance” & “Defeasance”

“In substance” means in essence and in business or commercial transactions. And that may not be in exact legal form. While “Defeasance” means retirement from liability i.e extinguishment of the liability. In other words, in the corporate and commercial world, it is one of the provisions in the loan. Whereby the loan obligations can be taken off or removed from the balance sheet, in substance.

Though legally and technically till final pay off a loan or bonds issued remains a loan or bond. And therefore, it is a liability in the books of accounts of the company and needs to be shown that way. However, by the process and provision of Defeasance, it is still possible not to show that debt as debt obligations. There is a suitable provision in the GAAP in this regard.

The important point to re-iterate here is that this is all an accounting practice to improve the overall capital structure of the company. And to relieve the company of bond obligations once it sets aside the necessary funds in risk-free investments that on their own can take care of the bond obligations. However, the corporation continue to remain liable and the primary responsible for all the obligations towards payment of interest and principal. If be chance there is a shortfall in funds to service these obligations, the corporation is responsible to make good the same till the final redemption.

Consideration of In Substance Defeasance

The Company considers In substance defeasance when the Company has :

  1. Issued Bond as debt carrying principal and interest
  2. And have made investments in securities like treasury securities, U.S Government bonds, etc.

In such a scenario the corporation can opt for In Substance Defeasance.

As part of the bond redemption option, the company maintains a trust account/escrow account to repay the principal along with interest. The funds are channeled to the Trust Account. That is then invested in the U.S risk-free securities etc. And the investment balances are maintained in the permanent trust account to a level that can take care of the future principal and interest payment obligations comfortably.

In such a case, the debt is said to be “defeased”. And is no longer regarded as a debt obligation for the Company. Moreover, it does not appear in the Balance Sheet. Debt Obligation as well as the investments.

When can Company opt for In Substance Defeasance?

The Company can opt for In Substance defeasance when the invested securities’ interest is higher than the interest of the issued bond.

For instance: U.S treasury bonds are yielding a 10% return while the Company has long term debt of bonds at the rate of 5-6%.

Thereafter stage is set for In Substance Defeasance.

In Substance Defeasance

Why Company choose In Substance Defeasance ?

Pros

The benefits derived from using this tool are as follows:

  • Improvement in Debt Equity Ratio and thus increase the capacity of the company to go for further loans.
  • Recognition of increase in earnings and earnings per share
  • Improvement in current ratio
  • Improvement in Debt to total asset ratio
  • The window dressing of the balance sheet
  • Consistency in financial reporting and accounting.
  • The corporation with liquidity, lower or declining debt, and increased earnings per share make it more attractive to the investors. A clean balance sheet attracts investors.

Cons

  • The Company might face sudden/uncalled for liquidity problems before undergoing defeasance. So this impacts its credit rating and creates doubt in the eyes of the law and the investors.
  • The corporation declares itself bankrupt after defeasance would raise several questions on corporate governance.

History

This transaction was first adopted by the Exxon corporation in 1982. And thereafter many Companies followed the same practice. Exxon had a debt of $ 515 million and bought U.S govt securities and placed it into a trust worth $313 million.

The debt had an interest rate of 5-6% and market yield government securities fetched 14%. The difference between the carrying value of the government securities and deposited in trust accounts recorded as gain.

Importance of Irrevocable Trust

The asset placed in irreversible trust required to be risk-free. It eliminates risk because it is backed by the U.S government. Therefore, it is safe.

Such asset consists of:

  1. Securities guaranteed by the U.S.government
  2. Obligation of the U.S.government
  3. Securities backed by the U.S.government where interest and principal amount flow immediately through to the security holder.

The most important point, the maturity date of the assets set in the trust should match with the scheduled interest and principal payments.

None of the assets placed should be callable i.e called on demand because it does not guarantee to satisfy the scheduled payment. The callable asset on demand does not qualify for the timing requirement of the debts.

Illustration

Example :

Borrowing debts : $1,000,000

Interest rate : 6% annual interest

Maturity : 15 years

Prevailing market interest rate for 15 years treasury bonds: 6.5% pa

Current market rate for bond: 7% pa

Present value of debts $1,000,000 [email protected]% deposited in trust $964,055

Gain :1,000,000-964,055=35945

Disclosure Notes to the Financial Statement

The financial statements contain disclosure notes explaining the amount of debt placed with trust. It is beneficial for investors to take decisions.

References:

http://archives.cpajournal.com/old/16373962.htm


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Sanjay Bulaki Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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