For accounting purposes, ASC 405-20-40-1 states that debt is considered extinguished (and removed from an entity’s books) only when either (a) the debtor is released from its obligation based on having paid the creditor or (b) the debtor is legally released from being the primary obligor under the liability.

Excerpt from ASC 405-20-40-1

[A] debtor shall derecognize a liability if and only if it has been extinguished. A liability has been extinguished if either of the following conditions is met:

  1. The debtor pays the creditor and is relieved of its obligation for the liability. Paying the creditor includes the following:
    1. Delivery of cash
    2. Delivery of other financial assets
    3. Delivery of goods or services
    4. Reacquisition by the debtor of its outstanding debt securities whether the securities are cancelled or held as so-called treasury bonds.
  2. The debtor is legally released from being the primary obligor under the liability, either judicially or by the creditor.

Also relevant is the guidance in ASC 470-50-55-9 on transactions or events that do not result in extinguishment of debt.

ASC 470-50-55-9

The following situations do not result in an extinguishment and would not result in gain or loss recognition under either paragraph 405-20-40-1 or this Subtopic:

  1. An announcement of intent by the debtor to call a debt instrument at the first call date
  2. In-substance defeasance
  3. An agreement with a creditor that a debt instrument issued by the debtor and held by a different party will be redeemed.

FG 3.7 provides a comprehensive discussion on accounting for debt extinguishments.
If bonds remain outstanding until maturity, the debt obligation amortizes in the typical fashion as the NFP services the debt and satisfies the obligation over time. When bonds are repaid prior to maturity, however, the issuer removes the bonds (and any remaining debt issuance costs and discount or premium related to that issue, if applicable) from its books and recognizes a gain or loss on the extinguishment. The gain or loss is calculated by comparing the amount paid to retire the old bonds (the principal, call premiums, other costs of reacquisition) to the carrying amounts of the old bonds and related accounts written off. The mechanics of the calculation are discussed in FG 3.7.
If the old bonds were insured and the issuer retains the insurance policy to cover new bonds issued to finance the extinguishment, the unamortized prepaid bond insurance would not be written off with the other debt issuance costs but would remain on the books and continue to be amortized.
See FSP 12.11.1 for a general discussion of financial statement presentation and disclosure considerations for extinguishments.

11.4.1 Refunding bonds

“Refunding” is the process of paying off an outstanding bond issue using the proceeds from a new bond issue. The older bonds are referred to as “refunded bonds” and the new bonds are referred to as “refunding bonds.” In most cases, refundings occur prior to maturity of the bonds to take advantage of a decline in interest rates (much like a homeowner might refinance a mortgage to benefit from lower interest rates). Refundings might also be undertaken to remove or revise burdensome bond covenants or restructure debt service payments.
The structure of a refunding is affected by whether the bond indenture allows the issuer to repay the bonds prior to maturity. If so, this will be stated in an optional call provision (known as a “call privilege”) as distinguished from provisions for extraordinary calls and mandatory calls based on specified events. The bonds cannot be “called away” from the bondholder prior to the date specified in the call provision (the “call date”). If an issuer would like to refund bonds early but does not have a call privilege, or if the call date has not yet been reached on bonds that are callable, a refunding transaction might involve a defeasance.
Usually, issuing new debt to pay off the old bondholders will legally extinguish the old debt. For accounting and financial reporting purposes, however, in some cases the replacement of one debt obligation with another might be considered a modification rather than an extinguishment. When evaluating these transactions as extinguishments or modifications, NFPs are subject to the same guidance as business entities: ASC 470-50, Modifications and Extinguishments (in particular, ASC 470-50-40-6 through ASC 470-50-40-12) and ASC 405-20, Extinguishments of Liabilities.
FG 3.4 contains a comprehensive discussion of how to differentiate an extinguishment from a modification. The IRS rules for tax-exempt bonds also require a modification analysis for refundings. Its focus is on whether a refunding results in a “reissuance” of the old securities for purposes of complying with IRS regulations related to arbitrage and other matters. The determination made for IRS purposes has no bearing on the determination made for financial reporting purposes.

11.4.2 Interest mode conversions

Some bonds are structured as “multi-modal.” As explained in FG 1.4.4, variable-rate bonds issued with a "multi-modal" option provide the issuer with a contractual right to change the interest feature of the bond from one form to another (for example, converting a variable rate to a fixed rate; converting an auction-based variable rate to an index-based variable rate). FG 1.4.4 explains the steps typically involved in an interest mode conversion.
Because in most cases a mode conversion involves a tender (i.e., call) of the old bonds and marketing of new bonds (to new investors as well as existing bondholders), a mode conversion is similar to a traditional bond refunding. Thus, the accounting considerations described in NP 11.4.1 also apply to mode conversions. When considering the guidance in FG 1.4.4, it should be noted that the tender offer in a municipal securities mode conversion typically is mandatory. Investors cannot choose to continue to hold their bonds; all bondholders will be repaid.

11.4.3 Defeasance of municipal bonds

If an NFP would like to retire or refund outstanding bonds early but the issue does not contain a call privilege (or the call date has not yet been reached for a callable bond issue), it might undertake a defeasance. In a defeasance, the old bondholders are not paid off immediately, but instead will be paid either at maturity or on the call date, using proceeds that have been placed in trust for that purpose. While it is possible to effect a defeasance using an issuer’s own cash, typically a defeasance will use funds provided by proceeds of a new bond issue (i.e., a refunding).
When a bond issue permits defeasance, the necessary terms and requirements will be described in a “defeasance provision” contained in the indenture. A defeasance provision describes circumstances under which the issuer will be deemed to have repaid the bondholders in full and have the lien of the indenture discharged without having actually paid off the bondholders. Typically, defeasance requires placing funds into a defeasance trust or escrow in an amount that, when invested, will generate sufficient cash flow to pay all principal and interest (and if applicable, the call premium) on an outstanding debt issue through either the call date or maturity, whichever is required. The defeasance provision will specify the types of investments permitted to be held by the defeasance trust. Often, the trust will hold special risk-free US Treasury bonds called State and Local Government Securities (also known as SLGS or “slugs”), which are issued specifically for purposes of defeasance trusts. The maturities of SLGS can be tailored to match the maturities of bonds in tax-exempt advance refundings so IRS yield restrictions are not violated (see NP 11.7.1). SLGS can also be used for taxable advance refundings of tax-exempt bonds. The trust assets must be irrevocably pledged to repayment of the obligation to those bondholders and be beyond the reach of the issuer’s debtors in bankruptcy.
If the conditions described in the indenture are met, the bonds are considered to be “legally defeased,” and the issuer has no further responsibility for their repayment. Sometimes an issuer will request a “defeasance opinion” from legal counsel to verify that a defeasance trust has satisfied and discharged its covenants, agreements, and obligations with respect to refunded bonds.
Not every bond issue contains a defeasance provision. In those situations, an issuer might similarly set aside funds in trust to pay the debt service and any redemption premium on the prior bonds when due for purposes of making revenues pledged as security for a revenue bond offering available for other purposes; however, the lien imposed by the indenture is not released. This is sometimes described as an “in-substance” or “economic” defeasance. In-substance defeasance is defined in the ASC Master Glossary.

ASC Master Glossary definition

In-substance defeasance: Placement by the debtor of amounts equal to the principal, interest, and prepayment penalties related to a debt instrument in an irrevocable trust established for the benefit of the creditor.

In an in-substance defeasance, the prior bonds will continue to be regarded as outstanding debt of the issuer, with principal and interest payments made using the assets in the trust. If the trust funds prove insufficient to make all future payments on the outstanding debt, the issuer would continue to be legally obligated to make payments from the pledged revenues.
The primary accounting consideration associated with a defeasance is whether the old bond issue (and defeasance trust assets) can be derecognized for financial reporting purposes. As discussed at NP 11.4, debt is considered extinguished for accounting purposes only where (a) the debtor is released from its obligation by paying the creditor; or (b) the debtor is legally released from being the primary obligor under the liability. In a defeasance, the holders of the old bonds will not have been repaid; thus, the old bonds are considered extinguished for accounting purposes only if the debtor has been legally released from being the primary obligor. ASC 405-20-55-9 contrasts a legal defeasance and an in-substance defeasance.

ASC 405-20-55-9

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.

If the terms of the bond indenture are deemed to have been satisfied by establishing the defeasance trust so that the issuer is legally released from being the primary obligor, the old bonds can be derecognized (typically, along with the assets in the trust). Normally, a legal defeasance results in simultaneous de-recognition of both the liability and the assets placed in the defeasance trust. However, if there is an indication that the debtor has continuing involvement with the assets placed in the trust, an evaluation of the criteria of ASC 860-10-40-4 through ASC 860-10-40-5 may be necessary to determine whether the defeasance escrow trust may be derecognized. FG 3.8 discusses the requirements for derecognition of defeasance-related liabilities and assets, along with factors or indicators which may be considered in evaluating the form and extent of continuing involvement, if any.
If the proceeds to fund the trust were obtained from a new bond issue, a refunding is deemed to have occurred (that is, a replacement of the old debt with new debt). If the issuance has met the requirements for legal defeasance and thus satisfied the condition for extinguishment accounting, the financial statements will only reflect a single outstanding bond issue. In that case, the entity will need to evaluate whether a gain or loss should be recognized on the refunding, based on the considerations discussed at NP 11.4.
As described in ASC 405-20-55-4, an in-substance defeasance transaction normally does not meet the criteria to derecognize either the liability or the escrowed assets.

ASC 405-20-55-4

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:

  1. 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.
  2. The lender is not limited to the cash flows from the assets in trust.
  3. The lender does not have the ability to dispose of the assets at will or to terminate the trust.
  4. If the assets in the trust exceed what is necessary to meet scheduled principal and interest payments, the transferor can remove the assets.
  5. Subparagraph superseded.
  6. 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.

If the proceeds to fund the trust were obtained from a new bond issue, both the old and new bond issues will be reflected as obligations in the issuer’s financial statements, along with the assets of the defeasance trust. Because the old debt has not been “replaced” in this scenario, the analysis in of whether an extinguishment or modification has occurred is not necessary.
FG 3.8.1 provides additional general discussion on legal defeasance versus in-substance defeasance involving a broader range of transactions than just municipal bonds. For additional discussion of bond defeasance, see AAG-NFP 10.28 through AAG-NFP 10.34 and AAG-HCO 7.20 through AAG-HCO 7.26.

11.4.4 Reacquisition of bonds through open market purchase

An entity may decide to reacquire its own bonds by purchasing them through the market (open market purchases). As discussed in NP 11.4, a liability should be considered extinguished (and derecognized) if the debtor pays the creditor and is relieved of its obligation for the liability. This explicitly includes situations when an issuer reacquires its own outstanding debt securities, regardless of whether the reacquired securities will be retired or held by the issuer “in treasury” for possible future reissuance (as discussed in ASC 405-20-40-1(a)(4)). It would not be appropriate for the issuer’s financial statements to reflect the reacquired bonds as an asset along with an obligation for their repayment.

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