Debt defeasance

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 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. Although assets may have been transferred to a trust, the lender may or may not release the borrower as the primary obligor.

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. When preparing their opinion, an attorney may need to consider the nature of the assets transferred and the form and extent of continuing involvement with the trust by the borrower. An evaluation of the guidance in ASC 860-10-40-4 through 40-6 to determine whether the transferred assets may be derecognized by the borrower (and thus not drawn into any potential bankruptcy proceedings) may be necessary.

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 Transfer of cash to the defeasance irrevocable 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. While transfers of cash by the debtor to the trust are not within the scope of the ASC 860-10-40-4 through 40-5 criteria for derecognizing the cash by the debtor, the degree to which the debtor has continuing involvement with the trust or its assets may require an evaluation as to whether the debtor 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 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 statement reporting purposes. ASC 810 provides further consolidation guidance.

3.8.2 Transfer of non-cash financial assets to the defeasance irrevocable 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 40-6 to determine whether it has surrendered control over the transferred assets. Under that guidance, if the transferred assets have been legally isolated from the debtor (e.g., put presumptively beyond the reach of the debtor and its lenders, even in bankruptcy), then the debtor has surrendered control over the transferred assets, and the trust has obtained control of them. The isolation criterion is primarily a legal determination; a legal opinion is needed to evaluate satisfaction of this criterion. See TS2 for information on control criteria for transfers of financial assets.

If any of the criteria in in ASC 860-10-40-4 through 40-6 are not met, the debtor should not derecognize the transferred financial assets or the debt.

Chapter 4:

Preferred stock

4.1 Chapter overview

This chapter discusses the accounting for preferred stock, including classification and measurement and the accounting for preferred stock issuance costs, participation rights, and dividends. It also discusses the accounting for modifications and extinguishments of preferred stock.

This chapter does not discuss the accounting for common stock or convertible preferred stock (preferred stock which is convertible into the issuer’s common stock or another class of the issuer’s preferred stock). For information on common stock, see FG 5. For information on the repurchase of common stock, see FG 6, and for information on convertible preferred stock, see FG 9.