In-Substance Defeasance: Requirements and GAAP Rules

In-substance defeasance is a financial strategy where a company sets aside assets to cover payments for a specific debt. The goal is to remove the debt and assets from the company’s balance sheet for financial reporting. This makes the debt appear self-servicing, presenting a financial position with lower leverage. This approach was historically used to improve financial ratios without legally settling the debt with the creditor.

Core Requirements for In-Substance Defeasance

An in-substance defeasance transaction required establishing a legally irrevocable trust. This trust held the designated assets, and its irrevocable nature meant the company forfeited all rights to access or reclaim them. The assets were placed beyond the company’s control to ensure the debt would be serviced without its involvement.

The assets placed in the trust were required to be risk-free monetary assets, limited to direct obligations of the U.S. government or securities it guarantees. These assets could not be subject to prepayment or recall, which would disrupt the cash flow schedule. This ensured that payments from the assets were highly probable.

Another requirement was the precise matching of cash flows. The interest and principal payments from the trust’s assets had to align perfectly in timing and amount with the debt’s payment schedule. This synchronization was intended to make the liability completely self-servicing and the probability of the company needing to make future payments remote.

Accounting for Debt Extinguishment

After the trust was funded, both the defeased debt liability and the assets placed in the trust were removed from the balance sheet. This derecognition of the asset and liability was the main accounting outcome of the strategy.

A gain or loss on the debt extinguishment was then calculated. This was the difference between the debt’s carrying amount and the cost of the assets placed in the trust. The carrying amount includes the debt’s face value adjusted for any unamortized premium, discount, or issuance costs.

For example, if a bond with a carrying amount of $980,000 was defeased with assets costing $950,000, a gain would be recognized. The gain on extinguishment would be $30,000, calculated as the debt’s carrying amount less the cost of the assets. This gain would be recognized on the income statement, while a loss would be recorded if the assets cost more than the debt’s carrying amount.

Applicability Under Current GAAP

The use of in-substance defeasance to extinguish debt is now largely prohibited under U.S. Generally Accepted Accounting Principles (GAAP). Accounting Standards Codification (ASC) 405-20 established stricter criteria for when a liability can be removed from the balance sheet.

Under current rules, a debt is considered extinguished only if the debtor pays the creditor or is legally released from the obligation by the creditor or a court. An in-substance defeasance transaction fails to meet these criteria. The company is not legally released and remains the primary obligor if the trust fails.

Narrow exceptions exist for certain debt issued with specific defeasance provisions before the rules changed in the mid-1990s. For any companies with such debt still outstanding, ASC 470-50 requires specific disclosures. These companies must provide a general description of the transaction and disclose the amount of debt considered extinguished but legally outstanding in the financial statement footnotes until it is retired.