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Corporate borrowing: cash flow implications of in-substance defeasance.

In an article in the September 1993 issue of The CPA Journal, William J. Coffey and Lewis Schier provided valuable information to companies evaluating long-term financing options. In particular, they discussed the advantages of sinking-fund debentures and in-substance defeasance. In a climate of rising interest rates, in-substance defeasance becomes an attractive option to companies because it results in higher reported earnings and a lower debt-to-equity ratio. As the authors pointed out, this may translate into improved credit ratings.

Companies considering this option, however, should be aware that the income statement and balance sheet benefits of in-substance defeasance may be offset by adverse effects on cash flow.

What Is In-Substance Defeasance?

In-substance defeasance occurs when a firm irrevocably deposits cash or other assets Into a trust for the sole purpose of making principal and interest payments on debt as the payments become due. The trust is restricted to owning virtually risk-free securities whose scheduled interest payments and maturity dates roughly coincide in timing and amount with those of the defeased debt. Although the debt is not legally satisfied, the irrevocable trust ensures that the possibility of the firm having to make future payments on the debt is remote.

The advantages of in-substance defeasance are twofold. First, if the defeasance occurs when prevailing long-term interest rates are higher than the rates in effect at the time the debt was issued, the amount of assets necessary to defease the debt typically will be less than its carrying value. This produces a gain, classified as extraordinary in the income statement.

Second, GAAP for in-substance defeasance, which is governed by FASB No. 76, calls for offsetting the trust assets against the defeased debt. The liability is effectively removed from the balance sheet, thereby improving the firm's capital structure.

What Are the Effects on Cash Flow?

Despite these advantages, in-substance defeasance may not be the best option from a cash-flow perspective. To illustrate this point, the following paragraphs describe the cash-flow consequences of the three typical financing alternatives identified by Coffey and Schier. Although they based their discussion on sinking-fund debt, we use term bonds instead to simplify the calculations involved, Sinking fund bonds would produce similar results.

Each alternative assumes the same debt: $1,000,000 of 6% bonds maturing in 10 years, originally issued at par with interest payable annually. The calculations further assume the current market rate of interest for bonds of firms with a similar credit rating has risen to 7%, while the interest rate on 10-year U.S. treasury bonds stands at 6.5%. Finally, the illustrations assume a corporate tax rate of 35%.

The firm carrying the assumed debt could simply allow it to mature as scheduled. Alternatively, the rise in interest rates makes two other options attractive. The company could either extinguish the debt through repurchase on the open market or employ in-substance defeasance. The cash flows associated with each of these options are summarized below and in the accompanying exhibit.

Retirement at Maturity. The exhibit shows the present value of the debt-related cash flows if the bonds are allowed to mature. Interest of $60,000 will be paid each year at an after-tax cost of $39,000. When discounted using the current market rate of 7%, the present value of this payment stream together with that of the $1,000,000 payoff at maturity is $782,269.

Open Market Repurchase. The exhibit also shows the present value of the cash flows required to extinguish the debt in the open market. The only difference in this amount and the figure previously determined is the $71,221 (present value) in income taxes that must be paid on the extraordinary gain from retiring the debt early. Thus, the total cash outflow associated with this decision is $853,490.

In-Substance Defeasance. To defease the debt, an irrevocable trust is created by purchasing treasury bonds in an amount necessary to fund the annual $60,000 interest payments plus the $1,000,000 payoff at maturity. Using a 7% discount rate, a total of $964,055 must therefore be deposited in the trust to accomplish the defeasance. Like the early retirement In the previous option, the difference between this amount and the carrying value of the debt is reported as an extraordinary gain in the income statement. However, the tax on this gain is deferred to maturity. In the interim, taxes must still be paid on the net interest earned by the trust after funding the annual $60,000 debt service. Thus, as the exhibit shows, the present value of these combined cash flows (the yearly tax payments on net interest earned, the tax paid on the gain deferred to maturity, and the initial deposit) is the highest of the three options, $978,981.

When is Defeasance Still Worthwhile?

Despite the sizable cash outflow it requires, in-substance defeasance may still be worth considering. Many companies are likely to conclude that the higher earnings and balance sheet improvement it produces outweigh the added cash burden. In addition, defeasance may be preferable when other factors make the alternative of early retirement less feasible. Debt that is widely held, for example, may be difficult to acquire through large open market purchases. Moreover, these acquisitions may involve high transactions costs or call premiums.

Nevertheless, any company contemplating in-substance defeasance should not overlook the impact on cash flow, or the qualitative consequences that may ensue. A firm might subsequently encounter unforeseen liquidity problems, for example, particularly if it was already experiencing financial difficulty prior to the defeasance.

Thus, in-substance defeasance could actually hurt rather than help a company's credit rating. Credit analysts may be skeptical of the motives behind defeasance, for instance, and choose to ignore the accounting gain and debt removal. When concerned with possible "window-dressing," they are likely to focus on new risks instead, such as the possibly increased likelihood of default on other existing debt.


  * $1,000,000 bonds due in 10 years, originally issued at par with 6%
interest payable annually

  * 7% current market rate (used for discounting)

  * 6.5% U.S. treasury bond rate

  * 35% corporate tax rate

Retirement at maturity:

Present value of debt service-payments:

10 annual net-of-tax interest
payments of $39,000 each                                          $273,920
$1,000,000 payoff at maturity                                      508,349

Present value of total cash payments                              $782,269

Open market repurchases:

Repurchase price                                                  $782,269

Present value of tax on (extraordinary)
gain from extinguishment(a)                                         71,221

Present value of total cash payments                              $853,490

In-substance defeasance:

Tax consequences of net trust earnings:

Year           Net Interest           Tax on  Net              Present Value
                Earned(b)              Interest

 1               $2,664                  $932                      $871
 2                2,837                   993                       867
 3                3,021                 1,057                       863
 4                3,218                 1,126                       859
 5                3,427                 1,199                       855
 6                3,649                 1,277                       851
 7                3,887                 1,360                       847
 8                4,139                 1,449                       843
 9                4,408                 1,543                       839
10                4,695                 1,643                       835

Present value of tax in net
earnings of trust                                                 8,530

Present value of tax on (extraordinary)
gain from extinguishment(c)                                       6,396

Amount initially placed in trust                                964,055

Present value of total cash payments                           $978,981

a 35% of $217,731 ($782,269 vs. $1,000,000 carrying value), discounted one
year at 7%

b Interest revenue less $60,000 annual interest payment

c 35% of $35,945 ($964,055 vs. $1,000,000 carrying value), discounted from
maturity at 7%

It is worth noting that credit analysts are not the only ones to question the merits of in-substance defeasance. Critics have often charged that the practice is misleading since the creation of an irrevocable trust only ensures the timely servicing of debt--it does not extinguish the liability. That is, until debt is actually settled, it continues to exist and should therefore remain on the balance sheet.

This criticism has opened the door to a possible reconsideration of in-substance defeasance. The FASB included the issue in its 1991 Discussion Memorandum on financial instruments, but has not as yet added the topic to its formal agenda. In the meantime, in-substance defeasance remains an option available to all firms. Those that are otherwise able to meet commitments and satisfy their cash demands may find defeasance a strategy worth considering.
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Title Annotation:Accounting
Author:Forsyth, Timothy; Fletcher, Stuart; Turpen, Richard
Publication:The CPA Journal
Date:Oct 1, 1994
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