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3.8 Debt defeasance
Publication date: 31 Dec 2022
us Financing guide
A borrower may enter into a defeasance, or refunding, arrangement with its lenders in an effort to derecognize its debt liability. A defeasance arrangement is generally a legal defeasance of the borrower’s liability to the lender, not a payment by the borrower to the lender. Defeasance arrangements may involve the borrower transferring an amount of cash or high-quality financial assets sufficient to service the debt obligation to maturity (or to an earlier call date) to an irrevocable trust. The trust undertakes the obligation to service the debt using the assets it has received.
To determine the appropriate accounting for a debt defeasance, a debtor should consider whether it has been legally released from being the primary obligor under the liability based on the guidance in ASC 405. If the arrangement involves the transfer of assets to a trust, it should determine whether it has surrendered control over the transferred financial assets based on the guidance in ASC 860-10-40-4 through ASC 860-10-40-6 and if it should consolidate the trust for financial reporting purposes (see CG 2 for information on consolidation of a trust).
When a lender releases a debtor as the primary obligor, it may require the debtor to become the secondary obligor (i.e., the debtor becomes a guarantor). Depending on the facts and circumstances, such an obligation could prevent derecognition of the liability. See FG 2 for information on the accounting for guarantees.
3.8.1 Legal defeasance versus in-substance defeasance
ASC 405-20-55-9 provides guidance on when a liability is extinguished by a debt defeasance.
In a legal defeasance, generally the creditor legally releases the debtor from being the primary obligor under the liability. Liabilities are extinguished by legal defeasances if the condition in paragraph 405-20-40-1(b) is satisfied. Whether the debtor has in fact been released and the condition in that paragraph has been met is a matter of law. Conversely, in an in-substance defeasance, the debtor is not released from the debt by putting assets in the trust. For the reasons identified in paragraph 405-20-55-4, an in-substance defeasance is different from a legal defeasance and the liability is not extinguished.
Whether a borrower has met the requirements for legal defeasance and consequently satisfied the condition for extinguishment accounting in ASC 405-20-40-1(b) is a matter of law. The best form of evidence to provide reasonable assurance that criterion ASC 405-20-40-1(b) has been satisfied is a legal opinion.
In an in-substance defeasance, the debtor transfers cash or high-credit quality assets to an irrevocable trust established for the benefit of the lender. The cash flows from the assets are used to pay the scheduled interest and principal payments on the debt; however, the lender does not release the debtor as the primary obligor for the debt. ASC 405-20-55-3 to ASC 405-20-55-4 provide guidance on an in-substance defeasance.
In an in-substance defeasance transaction, a debtor transfers essentially risk-free assets to an irrevocable defeasance trust and the cash flows from those assets approximate the scheduled interest and principal payments of the debt being extinguished.
An in-substance defeasance transaction does not meet the derecognition criteria in either Section 405-20-40 for the liability or in Section 860-10-40 for the asset. The transaction does not meet the criteria because of the following:
a. The debtor is not released from the debt by putting assets in the trust; if the assets in the trust prove insufficient, for example, because a default by the debtor accelerates its debt, the debtor must make up the difference.
b. The lender is not limited to the cash flows from the assets in trust.
c. The lender does not have the ability to dispose of the assets at will or to terminate the trust.
d. If the assets in the trust exceed what is necessary to meet scheduled principal and interest payments, the transferor can remove the assets.
e. Subparagraph superseded by Accounting Standards Update No. 2012-04
f. The debtor does not surrender control of the benefits of the assets because those assets are still being used for the debtor's benefit, to extinguish its debt, and because no asset can be an asset of more than one entity, those benefits must still be the debtor's assets.
3.8.2 Transfer of non-cash financial assets to a defeasance trust
When a debtor transfers non-cash financial assets (i.e., treasury or other governmental securities) to a defeasance trust, it should evaluate the criteria in ASC 860-10-40-4 through ASC 860-10-40-6 to determine whether it has surrendered control over the transferred assets. Under that guidance, the transferred assets must be legally isolated from the debtor (e.g., put presumptively beyond the reach of the debtor and its lenders, even in bankruptcy or other receivership), the debtor must surrender control over the transferred assets, and the trust must obtain control of the assets in order for them to be derecognized. The isolation criterion is primarily a legal determination; a legal opinion is needed to evaluate satisfaction of this criterion. See TS 3 for information on control criteria for transfers of financial assets.
If any of the criteria in ASC 860-10-40-4 through ASC 860-10-40-6 are not met, the debtor should not derecognize the transferred financial assets or the debt. Additionally, the debtor should evaluate whether it is required to consolidate the trust.
3.8.3 Transfer of cash to a defeasance trust
In conjunction with a defeasance arrangement, a debtor may transfer cash to a defeasance trust so that the trust can purchase risk-free investments (i.e., treasury or other governmental securities) to provide cash flows corresponding to the debt service requirements. A transfer of cash is not within the scope of ASC 860-10-40-4 through ASC 860-10-40-6. Nevertheless, the debtor should evaluate its continuing involvement with the trust (or its assets) to determine whether it has relinquished control over the assets in the trust. If the debtor has control of the trust or its assets, it may raise the question of whether the trust’s assets would be drawn into the debtor’s bankruptcy proceeding. A legal opinion similar in form to an evaluation under ASC 860-10-40-4 through ASC 860-10-40-5 may be required to conclude that the transferred cash has been put presumptively beyond the reach of the debtor and its lenders, even in bankruptcy.
The form and extent of the continuing involvement is a matter of judgment that depends on the relevant facts and circumstances. The indicators listed below should be considered in that evaluation; however, no one indicator should be considered presumptive or determinative. The relative consequence of each indicator or combination of indicators should be considered.
- The debtor maintains a residual interest in the assets of the trust
- The debtor may instruct the trustee to sell trust assets and purchase other assets
- The trust may seek investment advice from the debtor
- The trustee may apply at any time to the debtor for instructions, and may consult with counsel for the debtor as to matters arising in connection with its servicing of the trust
- The debtor is a secondary obligor to the liability assumed by the trust
If the debtor has a significant level of continuing involvement, and is not able to obtain a legal opinion concluding that the transferred cash has been put presumptively beyond the reach of the debtor and its lenders, even in bankruptcy, the debt should not be extinguished. Additionally, the level of continuing involvement may cause the debtor to have to consolidate the trust for financial reporting purposes.
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